Risk Tolerance vs Asset Allocation

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vikasa
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Risk Tolerance vs Asset Allocation

Post by vikasa » Sat Mar 08, 2014 12:23 pm

Generally speaking, does a risk tolerance of, say 5 (on a scale of 1 to 10) correspond to a asset allocation of 50% stocks and 50% bonds?

galao888
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Re: Risk Tolerance vs Asset Allocation

Post by galao888 » Sat Mar 08, 2014 12:32 pm

Statistically it should. However, in percentage terms that might equal a 25% loss at any given time or even clearer in money terms a loss of 125k on 500k.

steve_14
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Re: Risk Tolerance vs Asset Allocation

Post by steve_14 » Sat Mar 08, 2014 12:43 pm

I'd base my risk tolerance off time horizon, need to take risk, etc., not the answer to a survey question.

vikasa
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Re: Risk Tolerance vs Asset Allocation

Post by vikasa » Sat Mar 08, 2014 12:59 pm

How do you figure the 25% loss?

Yes, for a long time horizon (10+ years), with "medium" risk tolerance (maximize gains and avoid loss has equal weight), would that translate to a 50/50 stocks/bonds split?

I am just trying to quantify my risk profile into what mix of index funds /ETFs to buy. Instead of taking the one-size-fits-all approach of the Lifestrategy or Target Retirement funds.

dbr
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Re: Risk Tolerance vs Asset Allocation

Post by dbr » Sat Mar 08, 2014 1:08 pm

I think it is possible that the various schemes by which investment company questionnaires define a "risk tolerance" would generally line up the middle value with a 50/50 asset allocation. The Vanguard TR 2015 fund is 50/50 and rated at a risk of 3 on a scale from 1-5. That risk tolerance number you are referencing is not a recognized quantity that is calculated in financial analysis. The description that Vanguard gives of the meaning of those risk numbers is qualitative and fairly vague: https://personal.vanguard.com/us/funds/ ... =INT#tab=0.

The 25% loss number is not figured in the usual meaning of calculating a number; it is a rough statement based on the observation that stock markets occasionally lose as much as 50% during a market crash. A 50% loss is frequent enough to be worth worrying about, but market crashes of various magnitudes have happened including more than 50%.

Fallible
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Re: Risk Tolerance vs Asset Allocation

Post by Fallible » Sat Mar 08, 2014 1:41 pm

steve_14 wrote:I'd base my risk tolerance off time horizon, need to take risk, etc., not the answer to a survey question.
I also would skip the survey route. Here's an article by Rick Ferri on risk tolerance with mention of risk surveys followed by the link:

"Attempting to measure risk tolerance has never been easy and is especially difficult for new investors who have never been through a bear market. Many Wall Street firms and mutual fund companies have tried to commoditize this process by developing risk assessment questionnaires. This method involves answering a limited number of what-if questions, analyzing the answers, and recommending an allocation to equity."

The link: http://www.rickferri.com/blog/markets/p ... tolerance/
Bogleheads® wiki | Investing Advice Inspired by Jack Bogle

dbphd
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Re: Risk Tolerance vs Asset Allocation

Post by dbphd » Sat Mar 08, 2014 2:35 pm

I think the link to Vanguard's risk assessment provided in the first post of this thread is a pretty good place to start, because it presents the issues to be considered. The user can game answers and note their effect of projected risk tolerance. There are at least two distinct aspects of risk, the rational and emotional. Rational reflects ones ability to ride through financial vagaries; emotional reflects ones reaction to such vagaries. It's pretty easy to devise a questionnaire to discover rational risk, but not so emotional risk. But to disclaim that emotional risk can only be assessed by experience isn't very helpful. The Flight Path approach has been commonly known as get-your-feet-wet-first for years, and I suppose there's some wisdom captured in that. I personally prefer to pick an allocation that seems right for me in the long run and ignore the vagaries.

db

PB
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Re: Risk Tolerance vs Asset Allocation

Post by PB » Sat Mar 08, 2014 3:08 pm

With the important caveat that historical performance is no guarantee of future performance, I have found the allocation models to be a useful starting place as well:

https://personal.vanguard.com/us/insigh ... llocations

If you have real-world experience withstanding a major bear market without selling off, great; use that as your baseline. If you don't, my best advice is to really soul-search about withstanding the peak loss associated with each model without selling off, then err a touch on the conservative side of what you think you can tolerate. Because (1), the real world can often surprise people; and (2), the risk of losing a percent or three because you were a bit more conservative is better than erring on the greedy side; selling off in a bear market; then not being invested and facing the daunting task of figuring out when to buy back in. My experience both as an investor and observer suggests the 'greedy' approach can cost you a whole more, both financially and emotionally.

Finally, if you do find yourself panicking in a real world bear market, talk to people and even just (re)-read the classics before doing anything. There are useful approaches that can help you weather the storm - such as selling off just 10% and trying to hang in there from there. Whatever helps you avoid the big mistake of buying high and selling low.

Laura
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Re: Risk Tolerance vs Asset Allocation

Post by Laura » Sat Mar 08, 2014 8:19 pm

Past performance (good or bad) is no predictor of the future but here is a table offered by Larry Swedroe based on the 1970s bear market showing the amount of decline for various stock/bond allocations:

Max Equity - Exposure Max loss
20%...............5%
30%..............10%
40%..............15%
50%..............20%
60%..............25%
70%..............30%
80%..............35%
90%..............40%
100%.............50%

"Maximum Portfolio Loss X 2 = Maximum Equity Allocation"

Apply some of these percentages to your own portfolio to see how you feel. Watching a portfolio valued at $10k drop 40% is very different than watching a portfolio valued at $1 million drop 40%.

Laura
The views presented are my own and not necessarily those of the Department of State or the U.S. Government.

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