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Risk Tolerance: Assessed Through Real World Experience

A reader writes in, asking:

“I graduated this spring and found a job this summer. I enrolled in the 401-k to get the match but didn’t originally spend time considering which funds to use. Now I’m rethinking that decision. Do you know of any websites that will help me figure out my risk tolerance? I think my risk tolerance is low, but everyone says it should be high because I’m young.”

As we’ve discussed before, risk tolerance is made up of an economic/financial component and an emotional/psychological component.

I think your economic risk tolerance can be reasonably assessed with a questionnaire (e.g., how secure is your job? How large is your emergency fund? Do you have any debt? Could you significantly cut your monthly expenses if you had to?).

But I’m very skeptical of most quizzes that try to assess your emotional risk tolerance. Most such quizes ask you to consider how you would react to contrived hypothetical investment scenarios. In my opinion, the only way to really know where your emotional risk tolerance stands is to examine your real-world investing experience:

  • How did you actually feel last time the market crashed? Were you panicked? Somewhat worried? Entirely calm?
  • And what did you actually do with your portfolio? Were you able to rebalance back into stocks exactly according to plan? Were you unable to rebalance, yet not so scared that you sold your stocks? Or did you sell all your stocks and move to cash?

What If You Have No Experience?

If you’re just getting started investing, you don’t know how high your emotional risk tolerance is. And that’s OK. In fact, it’s unavoidable.

My suggestion for people just getting started is to just pick something. You won’t get it exactly right, but that’s OK. When you’re just getting started, the impact of your savings rate absolutely dwarfs the impact of your asset allocation. You have time and can afford to either a) make a mistake due to bailing out of a too-aggressive allocation or b) miss out on some years of good stock returns due to having a too-conservative allocation.

And, one way or the other, you will learn. The important thing is to not forget what you learn. For example, if you find that you get skittish when the market gets scary, remember that feeling and keep it in mind when the market is doing well and you’re tempted to move your stock allocation upward.

(Important note: As a new investor, despite having little with which to assess your emotional risk tolerance, you have all the applicable information for assessing your economic risk tolerance. So be sure not to use an allocation that’s more aggressive than your economic risk tolerance would allow. For example, don’t put any money into stocks that you can’t afford to have fall by 50% in the near-term future.)

In his recent book The Ages of the Investor, after suggesting that young investors start with a 50/50 stock/bond allocation, William Bernstein wrote the following, which I think nicely sums up what I’m talking about here:

“The young investor’s first encounter with a significant market decline serves mainly to ascertain her true risk tolerance. Her responses to the decline define the policy allocation that takes her to age 45 or 50. Does she panic and sell? Then certainly her long-term policy allocation to stocks should be less than 50%. If she holds fast but does not have the stomach to buy more, then 50% is likely about right. And if she piles in, then I say, ‘God bless.’ Perhaps she can increase her policy allocation to stocks to 60% to 80%. The next few decades should allow her to test, adjust, and repeat the process at least a few more times.”

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Comments

  1. I think risk tolerance is not a fixed concept across ages and amount of assets. When I had small amount of assets , I was zen like with the declines – a true boglehead -”this too shall pass”. Now that Iam accumulating more substantial assetts, dont know how I would do watching the life earnings being decimated.
    Just a personal observation.

  2. brandy,

    That’s an important observation, and my email correspondence suggests that you are not at all alone in that experience. So thank you for bringing it up.

  3. Mike,

    Re on “My suggestion for people just getting started is to just pick something. You won’t get it exactly right, but that’s OK. When you’re just getting started, the impact of your savings rate absolutely dwarfs the impact of your asset allocation. ”

    You hit it spot on. It’s funny how many newbies worry about the paltry sum of money they got in the market (yes, anything less than $100,000 is “paltry”, especially if you can max your Roth IRA and 401(k) annually – that’s $22,000 per year as of 2012). The key is to put in place an effective strategy for wealth accumulation to reach a “tipping point” – what I call the “snowball effect” where the magic of compounding starts to get amazing.

    Re Brandy’s: It’s more helpful to think in “percentage terms” than absolute amount. In absolute term: 25% decline in $1 million is obviously more than a 25% decline in $100,000. But that’s the nature of the market one needs to accept if you decide to be an investor rather than a market timer or speculator. If handling a 25% decline in $100,000 is easier for to bear for you than a 25% decline in $1 million – then you truly need to re-examine your investment strategy in concert with your life factors Mike mentioned “(e.g., how secure is your job? How large is your emergency fund? Do you have any debt? Could you significantly cut your monthly expenses if you had to?).” The more positive life factors you have on your side allow you to take more risk in the market – at least that’s how I see it.

    Lastly, asset allocation is really about how one sees money with respect to one’s ability to earn more of it and what that money represent. Some people are just way too risk-averse and attached to their money to be a successful investor (through whichever personal reasons) – an investor’s temperament towards money matters in the long run. All it takes is one silly blunder or panic for a porfolio to decline 50% or miss that 25% gain – and as the above Re to Brandy implies, the absolute amount can be significant.

  4. Funancials says:

    I see a lot of younger investors with over-aggressive portfolios because they were told they should be aggressive (rather than determining their own risk tolerance). I love the idea of “just do something.”

  5. Mike, very good point about just picking something for younger investors. I’m going to steal that line, but give credit of course! I have also written how your contributions and rate of savings are so much more important than AA, what stocks/bonds you pick, etc when you’re young. Thanks for correlating the two!

If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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