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Risk Tolerance in Action

Credit where credit is due: The inspiration for this article comes from a recent post on the Bogleheads forum: “A Time to Evaluate Your Jitters.” I strongly encourage you to read the post, as the author made his points more eloquently than I’ll be able to.

In the last week we’ve mentioned two productive things to do during a market downturn:

  1. Rebalance your portfolio, and
  2. Check for tax-loss harvesting opportunities.

Today let’s add a third: Get a first-hand evaluation of your risk tolerance.

Is Investing Supposed to Be This Difficult?

If my email inbox is any indication, many investors have found it difficult to stick to their investment plans this week. Their plans call for rebalancing (which in this case means selling bonds and buying more stocks), but they’re nervous about doing so.

Rebalancing isn’t supposed to be easy. Selling your better-performing assets to buy more of your worse-performing ones is difficult for most investors.

But it’s not supposed to give you an ulcer or heart attack either. If you’re experiencing that degree of hesitance to stick to your original plan, what you’re getting here is first-hand, concrete evidence that your risk tolerance is not as high as you thought it was.

If the only way you’re going to be able to sleep at night is to use a lower stock allocation than your original plan called for, then so be it. It’s a costly lesson, but it’s a valuable one too.

So don’t waste it.

Whatever stock/bond allocation you end up settling on, do not move to a more aggressive allocation in the future. Otherwise you’re likely to repeat the same mistake when the market takes its next downturn.

A lower-risk, lower-expected return allocation that you can stick with is much better than a higher-risk, higher-expected return allocation that has you panic-selling in every bear market.

But This is Unprecedented!

Several readers have told me that this week has been an exception. They’re normally risk-tolerant, but this decline has been particularly difficult to deal with because the events causing it are so unprecedented.

But that’s the point. It’s always unprecedented.

Think back to the end of 2008. The housing market was crashing. The biggest, most famous financial institutions were failing one by one, and experts were predicting that our entire financial system would literally collapse if the Federal government didn’t step in to hold the pieces together. It was unprecedented.

Or think back to 2001. The technology sector upon which we’d pinned our hopes of wealth and prosperity had started to come to pieces. Then, after about a year of the market declining, terrorists attacked us on our own soil, killing thousands of people. To say that that was unprecedented is an understatement.

Risk tolerance isn’t just about your ability to deal with abstract market declines. It’s about your ability to stay calm while your portfolio is tanking and you’re being inundated with news of frightening, sometimes genuinely catastrophic, I-never-thought-this-could-happen type events.

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  1. I have been in the same boat as many. Although I haven’t sold anything. I do have cash waiting to be invested. I actually considered looking at a long-term bond. I get the feeling my tolerance isn’t what I thought.

    I guess for me, I know I’m not very tolerant but “everyone” says I should be more than I am. I went pretty conservatively initially about 50% stocks and 50% bonds. I then went 40% stocks, 20% REIT, and 40% bonds split between TIPS and short-term treasuries. All is in ETFs through Schwab. At the moment all are about the same value, 25%. And you are right, thinking of selling the winners just to have “balance” doesn’t seem palatable. Neither does taking the cash I have and just buying the stock ETF because at this point it is likely to lose value in the short to mid-term.

    So I was thinking of the bond. At least with buying a straight bond, I know I’m getting something and it doesn’t go up or down.

    Anyway there is my unhelpful ramblings. :O)

  2. Hi Mike,

    I was one of those who e-mailed you recently and I see some of the wording from your reply in today’s opening post. It seems to me that one’s target allocation can get out of whack in two different ways: either from an asset class (most likely stocks) having been on an upswing (as in most of 2009-10), or because an asset class has taken a major hit (as in last week).

    In the first case when you sell off your higher performers, your overall balances have not been affected and you are selling high; in the second case your portfolio has seen an overall decline and you may be buying an asset class that has just lost value. It’s also a matter of how well you can absorb a loss (including such considerations as age, ability to meet expenses, employment situation, health, other assets/sources of income, etc.).

    This past week my allocation was rebalanced more conservatively than it had been, not by any panic selling of my own but purely by market forces that led to about a 10% drop in my portfolio. But since I am 3-4 years from retirement, I think I will stay with the more conservative allocation that has been forced on me (which in any case was my intention as I get closer to retirement). It became easy to be seduced by the rise in the market this past two years. But in my situation it’s not a matter of jitters or ulcers or the like, but rather a desire to know what, objectively speaking, is the most productive way to handle my money.

    Hope that’s clear. I felt some difficulty expressing what I wanted to say just now.

  3. Hi Larry.

    Yes, it’s true that I ended up saying a few things in several emails. So I decided to try to work them up into a more developed post in the hope it would be more useful.

    You wrote, “It’s also a matter of how well you can absorb a loss (including such considerations as age, ability to meet expenses, employment situation, health, other assets/sources of income, etc.).”

    I agree this is an important point. Risk tolerance isn’t just about mental/emotional stuff. As retirement nears (or in retirement), declines in portfolio value have a real economic impact. And much of risk tolerance is about how flexible you can be (or are willing to be) to deal with such things.

  4. Chris: I think you’ve made a good choice not to let other people set your risk tolerance!

  5. @Mike: “Risk tolerance isn’t just about mental/emotional stuff. ”

    Agreed. And in honesty, I wish it weren’t about emotional stuff at all. On the one hand, investors are (quite rightly) discouraged from making decisions based on panic buying or selling. On the other hand, they are encouraged to assess how comfortable they feel or whether they can sleep at night or their peace of mind. But how your money behaves has nothing to do with your sleep patterns. The goal should be to make productive decisions based on how money actually works.

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