In an interview with Money Magazine editor Eric Schurenberg, author/associate professor/retirement expert Moshe Milevsky made the following statement that I particularly enjoyed:
I think advisers tend to take the mental aspect a little too far. People’s risk tolerance changes every day. Yesterday the market is up: People are risk tolerant. Today the market plummets: They’re no longer risk tolerant. You should build your retirement portfolios on something more stable than just your mood this morning.
I think Milevsky makes a great point that it’s all to easy for an investor to let 5 consecutive years of positive returns lure him into thinking that he’s more risk tolerant than he really is.
What I really like though is that he brings up the idea that risk tolerance isn’t a static thing. This is something I’ve been pondering myself as I’m working my way through The Four Pillars of Investing.
The author (William Bernstein) suggests in a few places that you should guess conservatively when estimating your risk tolerance. That is, if you think you’re a pretty risk tolerant person, who could handle the volatility that comes with a 90% stock portfolio, it’s likely better to try an 80% stock portfolio just to ensure that you don’t panic when things go wrong.
That’s the conventional wisdom. And it makes sense. But you already know how I feel about it.
Also, this type of suggestion assumes that a person’s risk tolerance is set in stone.
Doesn’t knowledge increase risk tolerance?
To me, the more a person knows about markets (and, more specifically, their cyclical nature), the greater her risk tolerance. After all, if you’ve researched enough about market history, you know that downturns are followed by upturns. That’s just how things work.
And if you’re perfectly calm during a market crash because you’re aware that the market will come back up at some point, isn’t that the very definition of risk tolerance?
So if knowledge leads to confidence (and confidence is the same as risk tolerance), doesn’t that mean that a person can increase his risk tolerance simply by taking the time to educate himself about market history?
And finally, if a person can increase his risk tolerance via learning, wouldn’t this be a worthwhile thing to do (as opposed to simply being content with a more conservative/lower returning asset allocation your whole life)?
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Knowledge increases the understanding of risk itself. If you understand risk well, you tend to make better decisions. This is a good point your making.
Interesting subject. It’s partly outside the realms of discussion and into psychology I guess.
Another reason to act conservatively (not that I follow this suggestion) is the asymmetrical response we have to loss versus gain.
If you feel twice as bad when you lose 25% as you feel good when you gain 25%, that’s a clear reason to err on the side of caution.
But then again, perhaps I’ve just worked my way around back to the definition of risk tolerance?!
It can hurt when outsize gains elude you – as me or anyone else who wasn’t invested in dotcoms in 1999 can tell you. But not as much as the losses 2000 pained those who were, I’m sure.
Hi Monevator.
Thanks for bringing that up. I’ve always been intrigued by the “pain from loss is more powerful than pleasure from gain” phenomenon.
In fact, it’s one of the main ideas behind this blog (although I suppose I don’t talk about it often). As far as I can tell, the pain of loss is also directly proportional to how often you think about it.
I’m sure that for those who check their portfolios everyday, the current market decline has been far more emotionally painful than for those who merely take a look every few months.
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