When determining your ideal asset allocation, by far the most important question is what portion of your portfolio should be in stocks and what portion should be in bonds (or cash).
To answer that question, you have to assess your risk tolerance, which is made up of your need to take risk and your ability to take risk.
Determining Your Need to Take Risk
Your need to take risk is a function of the level of expected returns you require in order to meet your goals.
Example 1: Steve recently retired after working for the Federal government for 35 years. His pension completely covers his living expenses. Steve has no need to take risk in his portfolio.
Example 2: Samantha hopes to retire in 10 years. Samantha has calculated that at her current savings rate, she needs to earn an inflation-adjusted annual return of 6% in order to retire as planned. Because Samantha will not be able to meet her goal with very low-risk investments like CDs or TIPS, she has a need for risk in her portfolio.
In short, the greater the return you require, the greater need you have for risk in your portfolio.
Of course, it’s not as simple as turning the “equity allocation” dial upward and assuming you’ll earn higher returns for doing so. Sometimes, increasing your equity allocation backfires. That’s why you also need to consider your ability to take risk.
Determining Your Ability to Take Risk
Your ability to take risk is a function of:
- How flexible your goals are, and
- How emotionally comfortable you are with volatility.
Example 1: Debbie is 54. She hopes to retire at 62 with enough savings to provide for $50,000 of annual spending. Debbie likes her work though, so she wouldn’t terribly mind having to work until her late 60s. And $50,000 is just a goal. She knows she could get by just fine with about 70% of that. Because Debbie’s goals are flexible, she has a higher ability to take risk.
Example 2: Jason is a construction worker. He’s 52, and each day he is becoming increasingly aware that his body is unlikely to be able to continue in his line of work for more than two or three more years. Between his Social Security and savings, Jason is pretty sure that his basic expenses will be covered–but only barely. Because Jason can neither delay his retirement nor reduce his expenses, Jason has a low ability to take risk.
In addition to considering the flexibility of your goals, be sure to take into account your personal comfort level with volatility in your portfolio. Questions you might want to ask yourself would be:
- What’s the maximum amount of loss I could handle without wanting to sell everything and move to cash? (Try answering this question both as a percentage of your portfolio balance and as a dollar amount.)
- How would I respond to two consecutive years of losses? What about three consecutive years?
- How would I respond to two consecutive years of double-digit losses?
The less comfortable you are thinking about such things, the less ability you have to take on risk in your portfolio.
Need and Ability Don’t Always Work Together
As you might imagine, the two components of risk tolerance are as likely to work against each other as with each other.
Many investors have a high need for risk, but very little ability to take risk. In such cases, there’s no particularly good answer. The best solution typically involves making difficult sacrifices.
In contrast, some investors are fortunate enough to have a high ability to take risk, but very little need to do so. They can choose between an aggressive, moderate, or conservative portfolio. Any of the three is likely to work out fine.
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Nice overview. I see a number of people who don’t need to take a risk actually put a high allocation in risky assets. They feel they worked hard to accumulate assets and can’t stand to see them earn piddly Treasury bill returns! This, of course, can backfire as in 2001 and 2008. All I can do is point this out to them
What about Options in a portfolio for someone that has discretionary income, but a moderate level of risk. Options to my knowledge are very risky assets to have, but as you just said (paraphrasing) high risk equals high reward. Isn’t this gambling?
What if you have someone who is retiring in say 5 years, and is about 8 years away from their goals. They are adamant about retiring in 5 years, but discretionary income isn’t their this time. Do you advise the option route?
Hi Uriah.
There are a lot of different options strategies out there. Not all are high-risk with high expected return. In fact, some are used to reduce the risk (and expected return) of a portfolio.
My opinion on options though is that there are very few individual-investor-situations* in which options strategies make sense rather than simply picking a portfolio with an appropriate asset allocation. (That is, you can increase or decrease the risk/expected return of a portfolio without having to resort to options. If you felt a situation called for a very high risk level, you could simply increase the allocation to equities or increase the allocation to particularly high-risk equities like small-cap/value stocks.)
So to answer your question, no, I probably wouldn’t advise using options in such a scenario. (Nor, for that matter, would I likely suggest a high-risk portfolio in such a scenario.)
*To provide example of when options might be useful for achieving a goal that cannot be achieved using simple asset allocation: Consider an investor who has a significant amount of his assets in his employer’s stock (because of a retirement plan that allows for purchases below market price, for example). In such a scenario, it might make sense to buy put options on that stock in order to protect against loss.
I have a question about Steve, in example 1.
You say:
Example 1: Steve recently retired after working for the Federal government for 35 years. His pension completely covers his living expenses. Steve has no need to take risk in his portfolio.
Since his pension covers his living expenses, what is the reason for his portfolio? Without risk, the portfolio probably won’t grow much. He doesn’t need it for daily stuff, but he could leave lots more to heirs, or take bigger trips, or a variety of things, if his portfolio was larger. I would think that since he doesn’t “need” his portfolio, he can take lots of risk, and maybe have it grow into something special…
Julie: You’re right. He could take on a lot of risk if he chose to. (That is, his need is low, but his ability is high.) It all depends on what his goals are.
Great post. Inspiring!
To Julie’s comment, I think it comes down to priorities, which will define need. If Steve would rather take more risk so he can leave a larger estate behind, or take more/bigger vacations, then he would have a valid need for the additional risk. But if Steve didn’t have such priorities. It would not make sense for him to take more risk because he is able to.
Perhaps a better way to make an example of Steve would be to say that after taking his pension into account, his other retirement assets don’t really need to grow much more to cover his desired living expenses.
My emotional comfort with risk has been changing. Actually, I have no emotional comfort with risk. However, too bad for me because the world is risky and there’s no escape. What I really mean is that my handling of my emotional discomfort with risk has been changing.
I was a kid in the 70’s, so I know about inflation, so I know that investments that are called safe are not necessarily safe, though they do tend to have lower volatility than investments that are called risky. And I know that over the long term, stocks bring in more than bonds, so that helps with long-term risk. And I know that over the short term, any asset class can be earning the highest returns or the lowest returns, and this keeps changing. So diversification helps reduce short-term risk.
I played some stock buying games and learned that although sometimes I have a good feel for where a stock is going in the short term, this is not reliable enough for me to invest much money in it. When I started buying real stocks, I started with an amount I could afford to completely lose. Now I realize that with a diversified portfolio, the most I’m likely to lose is one half or maybe two thirds of the value. And generally sometime after that point, there is rapid growth to make up for some or all the loss.
So basically, although I am completely risk averse, my grip on reality has taught me to deal with that through diversification (and fee minimization) rather than by freaking out and selling during stock plummets. So far, I’ve always been able to convince myself that plummets are the time to buy (though I was wrong about Japan’s plummet all those years ago) rather than to sell. Oh, I also don’t leverage, buy junk bonds, or (except when I’m willing to risk losing it all), buy risky stocks of new companies.
And so my point is that although emotional comfort with risk is tied to personality, it can be modified through education.
Debbie: I have absolutely nothing of my own to add, but I really like the way you explain your learning process. So thank you for sharing.
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