Do you want to increase the probability of meeting your unique investing goals?
Selecting the right mix of stocks and bonds is your “asset allocation” decision. It is essential if you want to meet your unique financial goals.
But before you can pick your asset allocation, you must understand your unique risk tolerance.
It can be helpful to break your risk tolerance into two factors:
- Your ability to take risk; and
- Your willingness to take risk.
Your ability to take on risk is rooted in your circumstances. Examples include your age, the time horizon of your goals, income stability, debt levels and expected pension income in retirement.
In contrast, your willingness to take on risk is based on your emotional fortitude in the face of volatility.
In this post, I will help you determine your unique risk tolerance and set an appropriate asset allocation.
Table of Contents
Why Is Risk Tolerance Important?
Let’s look at Fred and George, who both fail to assess their unique risk tolerance.
First, consider Fred, who panic-sold his 100% stock index portfolio during the 2008 crash when the market fell by 56%. After seeing the market rebound for 4 years, Fred re-invested his money in 2012. Fred again panic-sold his investments for a 30% loss at the bottom of the COVID crash.
Fred took on too much investment risk relative to his willingness to take risks. He lost wealth and delayed retirement by ten years.
Now consider George, who is debt-free with a government job and a robust emergency fund. George considers stocks and bonds “gambling” after seeing his brother Fred lose money due to poor emotional control.
George saves $1,500 a month in his retirement account and keeps it in cash-like assets like GICs (CDs in the US). His savings are eroded by inflation over his working career. Retirement is delayed.
Fred took too much risk relative to his risk tolerance. George took on too little risk relative to his risk tolerance. Both failed to build wealth and may not meet their financial goals.
Understanding Risk for Stocks, Bonds and Cash
A key study on financial literacy shows that people are deficient in their understanding of risk and diversification.
So before reading further, I recommend you understand investment risk for stocks, bonds and cash.
Finally, when I talk about investing in stocks and bonds, I refer to total market index funds. These funds maximize risk-adjusted returns through diversification for a given asset class (stocks/bonds)
What is Willingness to Take Risk?
I define willingness to take risks as your capacity to remain invested despite emotional discomfort. It’s your behavioural tolerance to market volatility.
Consider that $10,000 invested in the S&P500 index in 1970 would be $1,939,900 in 2023. These are great returns, but it was not a smooth ride.
During the 53-year window from 1970 and 2023, the S&P500 crashed by:
- 48% in 1972
- 49% in the early 2000s
- 57% in the 2008 financial crisis
- 34% in 2020 during the COVID crash.
To acquire these investment returns, one must remain invested despite emotional discomfort.
For most young investors, willingness to take risk is the LIMFAC (limiting factor). To see why, read my section below on ability to take risk.
The Cost of Exceeding Your Willingness to Take Risk
The average investor underperforms the market, buying high and selling low. Such behaviour is the outcome of insufficient willingness to take risks.
When markets crash, humans tend to panic sell in the face of excessive discomfort.
When times are good, people tend to jump into speculative assets in response to fear of missing out.
People who exceed their willingness to take risks tend to buy high and sell-low – hardly a formula for building wealth.
How To Test Your Willingness to Take Risk
Ask yourself: “What would I do if I lost 50% of my investment portfolio and had to wait six years to recover?”
Is your response to sell everything and never invest again? If so, you are not willing to take on the risk of 100% equities (stocks). There is nothing wrong with that.
You can repeat this exercise for various asset allocations to find your unique risk tolerance. Here are the worst one-year losses over the past 50 years for different asset allocations:
- 100% stock, 0% bonds: -37.5%
- 80% stock, 20% bonds: -31.2%
- 60% stock, 40% bonds: -25.4%
- 40% stock, 60% bonds: -18.9%
This data is from the Canadian Portfolio Manager Model Portfolios for a total market globally diverse index fund. Expect worse outcomes with less diversified portfolios.
For more info, check out The Past 30 Years of Stock Returns: Top Pains and Gains.
Top 3 Factors That Affect Willingness to Take Risk
Everyone has a unique capacity to tolerate investment ups and downs. Your willingness to take risks is unique to you.
A low willingness to take risk is nothing to be ashamed of. A complex array of factors influence your comfort with short-term financial loss.
But there is good news. There are actions you can take to increase your willingness to take risk.
1. Confidence In The Underlying Sources of Asset Returns
When bananas go on sale, humans buy more of them. But when businesses go on sale, people run away.
A stock represents a portion of a business. Understanding this reality can change how you view a market crash. Instead of being afraid, you may view a crash as an opportunity to buy businesses for less money. They are on sale.
Bonds are even more mechanical. When interest rates go down, bond price fall. At the same time, future bond returns go up!
A firm understanding of investment basics, such as the source of stock returns, can help you mitigate the emotional pain associated with volatility. Therefore, strong investing knowledge can increase your willingness to take risk.
2. Capacity For Emotional Control
Investing success depends primarily on emotional control. Technical competence comes secondary.
The hardest part of investing is leaving your portfolio alone during crashes and during times of speculation.
As markets crash, people become fearful, thanks to loss aversion. Likewise, when friends make money in speculative assets like bitcoin, you may fear missing out.
Self-Regulation
I often view life as a battle between my inner adult and my inner toddler.
The inner toddler wants to speculate and panic sell, but my inner adult has to keep the toddler under control.
A similar analogy of a rider trying to control an elephant is used in the book Happiness Hypothesis by Johnathan Haidt. Self-regulation is central to wellbeing.
In addition, self-regulation (self-discipline) is a function of a strong pre-frontal cortex. I believe you can train and improve self-regulation by doing hard things.
For more ways to control your natural biases when investing, check out 7 Ways to Control Your Emotional Biases.
3. Portfolio Size Relative to Income
A 10% loss on a $10,000 portfolio is $1,000. But a 10% loss on a million-dollar portfolio is $100,000.
As your portfolio size grows, the up-and-down fluctuations hurt more. A larger portfolio places larger demands on your willingness to take risks.
The opportunity to progressively increase willingness to take risks is a benefit of investing while young.
Through trial and error, young investors can progressively increase their emotional fortitude. Such experience can help you remain invested when there is more at stake in later years when you have a larger portfolio.
From Willingness To Ability to Take Risk
Maybe you have a stomach of steel and can tolerate a mountain of investment risk. If this is you, congrats … you are a rare breed.
But before getting too far ahead, you also need to have the ability to take investment risks.
What Is Ability to Take Investment Risk?
Your ability to take risk is based on the mechanics of your unique financial goals rather than your emotional fortitude in the face of volatility.
After thinking about this for two weeks, I believe your ability to take risk can be broken down into the following three factors:
- How long until you start portfolio drawdown for consumption?
- What fraction of your portfolio is required to fund future consumption?
- How certain are you that your life circumstances don’t require you to dip into investments before your planned portfolio consumption?
Determine Your Ability To take Risk: Top 8 Factors
Let’s cover eight factors that influence your ability to take risk. You can consider your unique situation against these factors when assessing your own risk tolerance.
1. Investment Goal Time Horizon
How long can you remain invested before you need the money? The time until the money is required is called your time horizon.
A long time horizon increases your ability to ride out the ups and downs of riskier investments like stocks.
To see why your time horizon matters, consider the S&P500 index in the US between 1995 and 2015.
If you want to buy a house in 4 years, stocks are the wrong place for the down payment!
Even a longer periods, like a decade can result in low returns. For example, from 2000-2010 a US S&P500 index fund returned -0.9% annualized, with dividends reinvested.
2. Your Emergency Fund and Ability To Take Risk
Emergencies pop up without notice and can have a time horizon of days or weeks. Effectively zero.
Liquid cash is the only acceptable asset for an emergency fund.
To see why, consider what happens if you have no emergency fund during a market crash. In the case of an emergency, you must sell off your portfolio (perhaps at a loss) to fund your emergency expense. Alternatively, you may need to take on debt.
Taking on debt or dipping into your investments to fund an emergency expense reinforces lousy personal finance behaviours. A portfolio is best left alone. Untouched.
The emergency fund provides a buffer to help you leave your investments alone to compound in the background.
3. Human Capital, Financial Capital, and Ability to Take Risk
You may wonder” “why does a younger investor have a higher ability to take risk relative to an older investor (with all else held constant)?”
Most of a young investor’s wealth is held in their human capital. But first, you may also wonder, “what is human capital?”
Financial assets like stocks, bonds and real estate are priced based on their future income-producing power using discounted cash flow (DCF) analysis.
Likewise, your expected future income can be priced under DCF. The price is your human capital.
Total wealth = human capital + financial capital.
With a significant fraction of wealth in human capital, a young investor is better able to absorb the loss of financial capital.
An older investor relies primarily on financial capital for income and has less human capital. A 50% stock market crash reduces an older investor’s total wealth more than a young investor.
To summarize:
- A high ratio of human capital to financial capital: increased ability to take risk.
- A lower ratio of human capital to financial capital: reduced ability to take risk.
4. Income Stability Increases Ability To Take Risk
A stable job, like a government job, provides consistent income (cash flow). Such a job is less likely to evaporate at the depths of a recession.
Therefore, employment in a safer job makes your human capital more of a bond-like asset. The cashflows (income) are steady and well-defined.
With job stability, your human capital is more stable; therefore, your total wealth (see above) is more stable.
Looking at it another way, you are far less likely to need to dip into your investments to fund your consumption, becuase you are more likely to remain employed.
A stable job improves the stability of your human capital. In turn, you can take more risk with your financial capital.
5. Debt Reduces Ability To Take Risk
Investing with debt increases your exposure to investment risk. Having debt in your life reduces your ability to take risks.
Such debt may include:
- Lines of credit
- Student loans
- A mortgage
First, I’ll show why borrowing money to invest increases risk.
Borrowing money to invest is called leverage, and it increases exposure to investment risk. In exchange for this extra risk, you can expect higher returns.
But leverage magnifies returns: good and bad. When asset prices fall, not only do you lose some of your own money, but you lose borrowed money as well!
Here you can see that the market return is magnified by a factor of two with 50% leverage.
It may not seem intuitive, but it doesn’t matter exactly where the debt is located. You are still leveraged.
Having a mortgage, student loan debt or a line of credit debt reduces your ability to take investment risk.
6. Defined Benefit Pensions Increase Ability To Take Risk
Guaranteed income from defined benefit (DB) pensions provide a stable cash flow in retirement, thereby increasing your ability to take risk.
Perhaps the pension is a universal government pension, like CPP in Canada. Or maybe it’s an employer-provided defined benefit pension.
DB pensions produce reliable cashflows in retirement and shift investment risk onto the employer. Therefore, you are better able to tolerate more risk with your portfolio.
Another perspective is that a DB pension in retirement can cover some of your retirement expenses. Therefore, you are less reliant on your portfolio to provide income. See how to size an investment portfolio for retirement in this post.
You are better able to take on risk with your portfolio.
7. Fraction of Portfolio Needed For Drawdown
Imagine that you have a $1,000,000 investment portfolio. In addition, you have a $30,000 expense upcoming in 5 years for a new car.
The new car represents 3% of your portfolio’s value. You can tolerate a 50% downturn and still be able to fund the car. It doesn’t take a massive chunk out of your portfolio.
Therefore, a larger portfolio, relative to the expense, can help you tolerate more investment risk. This relates to the strength of your balance sheet.
8. Consumption Flexibility In Retirement
How flexible is the timing of your investment goal? The flexibility to push portfolio drawdown by multiple years can increase your ability to take risk.
I’ll go through an example. Over the past 7 years, it made more sense for me to rent and invest. In about 5 years, I intend to use a portion of my portfolio as a down payment to purchase a home.
Five years is too short of a time horizon for stocks. But my girlfriend and I are willing to shift our home purchase date in response to poor market conditions.
If the home purchase goal was rigid, I would only hold cash-like assets. But due to flexibility, my downpayment money is in a 60% stock, 40% bond portfolio.
Should the market tank, I will simply delay home ownership and continue renting and investing.
Flexible investment goals increase your ability to take risk by effectively increasing your goal time horizon.
Questionnaires: Estimate Risk Tolerance and Asset Allocation
Below are two questionnaires to help you estimate your risk tolerance and asset allocation.
Estimating your asset allocation can be complex. It is one of the core duties of a financial professional. I can help you with this via a financial coaching session.
Sometimes, you need to experiment to find your unique risk tolerance. In the process, you’ll get to know yourself better. Then you can adjust your risk tolerance based on how well you sleep at night.
Asset Allocation: Engineer Your Risk (And Returns)
Asset Allocation: Stock/Bond Mix
The most common method to engineer your investment risk exposure is to change the mix of stocks and bonds you invest in.
Stocks are riskier (more volatile) than bonds. Therefore, they have higher long-term expected returns. For example, global stocks have outperformed global bonds by 3.1 %/year (source) since 1900.
High Risk Tolerance: Leverage and Value Stocks
There are two options to increase risk past that of 100% (market cap weighted) stock portfolio.
The first option is leverage, where you take on debt to invest. As described above, investing with any debt is a form of leverage.
Holding Small Cap Value (SCV) stocks is the second way to increase risk exposure. Value stocks are riskier than growth stocks and have higher expected returns. I cover data on SCV returns here.
Notice that I don’t talk about increasing risk by holding individual stocks. The excess risk (relative to an index) associated with an individual stock is not compensated.
In an efficient market, holding individual stocks increases risk without expected reward (in an efficient market).
Time Horizon and Asset Allocation Rules of Thumb
Financial goal time horizons constrain your ability to take on investment risk in the following ways:
- Money needed within five years: Cash-like assets only—no investing in stocks or bonds. Learn about other options to meet short-term savings goals.
- Money needed in 10-15 years: 60% stock, 40% bond portfolio.
- Money needed in 20+ years: 100% stock portfolio.
Asset Allocation and Returns: The Relationship
Here are the returns for a globally diversified stock and bond index fund portfolio over the past 50 years (source). Note the lowest one-year returns.
As you take on more (compensated) investment risk, you increase expected returns.
% Bonds | % Stocks | 50 Year Annualized Return | Lowest 1 Year Return |
80% | 20% | 6.85% | -12.2% |
60% | 40% | 7.33% | -18.9% |
40% | 60% | 7.75% | -25.5% |
20% | 80% | 8.11% | -34.7% |
0% | 100% | 8.40% | -37.5% |
Risk Tolerance Changes: Asset Allocation Responsiveness
Your risk tolerance is not static. Time horizons contract as you get closer to your goals. Income stability may change. And as you age, your wealth transitions from human to financial capital.
As your ability to take risks changes, so should your asset allocation.
Target date funds are an excellent example of adapting your asset allocation in response to your age.
Target date funds shift your assets from stocks to bonds progressively as you approach retirement age. For example, the Vanguard 2065 target date fund has a 90% stock, 10% bond allocation in 2023. But in 2070, it will have a 30% stock, 70% bond exposure.
As investors in the target date fund get closer to retirement age (2065), the fund shifts its asset allocation from stocks to bonds. It responds to the changing risk tolerance of the underlying investors.
Conclusion
- Overall risk tolerance can be broken down into your willingness and ability to take investment risk.
- Your willingness to take risk is based on your degree of emotional comfort during volatility. Willingness to take risk is often the limiting factor for young investors.
- Ability to take risk depends on financial goal time horizon, age, defined benefit pension income and income stability.
- Once your risk tolerance is understood, you can engineer your portfolio’s risk exposure to match your unique risk tolerance.
- By matching investment risk exposure with your risk tolerance, you improve the probability of meeting your financial goals.
I hope you found this post helpful. For more personalized help in finding your risk tolerance, set up a financial coaching session.
Jake out.