Finding the risk tolerance for AA

Have a question about your personal investments? No matter how simple or complex, you can ask it here.
Post Reply
Topic Author
StoneFeeler
Posts: 26
Joined: Wed Feb 20, 2019 3:23 am

Finding the risk tolerance for AA

Post by StoneFeeler » Wed Mar 13, 2019 12:45 am

Personal situation: Self 53 years, Wife 48 years, no other financial needs (kids provided for), trying to deploy 3 mil for 10-15 years when I expect to begin retirement and drawdown, no addition to savings expected until then.

In this situation, I am trying to estimate my risk tolerance to determine the AA. I have tried various things:

1. Age in bonds: According to this, I should be 50% in bonds.

2. VG risk questionnaire: This one seemed pretty generic to me. How do I know how I am going to react if there is a 20% fall in the value, etc?! Still, I went ahead and tried to best-guess it. It gave me a recommendation of 50/50.

3. I tried to study the historical drawdown charts in some websites for different allocations to help me imagine how much pain I can take. (For example: https://paulmerriman.com/fine-tuning-tables-2018/) Again the question is: how do I judge how I would react to these numbers without being in the situation?

4. I tried retirement calculators such as Firecalc. According to that, if I have 3 mil at the beginning, I should be okay. But I have another 10-15 years to go before I start drawing down and I need to figure out an AA for that period.

I understand that risk tolerance and AA ultimately boil down to one's own judgment, but how do I make the best judgment possible? Any other resources I should read or study?

Thanks!
"Crossing the steam by feeling the stones"

DonIce
Posts: 719
Joined: Thu Feb 21, 2019 6:44 pm

Re: Finding the risk tolerance for AA

Post by DonIce » Wed Mar 13, 2019 1:26 am

After having lived for 53 years, do you not have any instances in your life when you experienced some adversity that you can think back to and try to remember how you reacted to those situations? Were you emotional? Did you make irrational decisions? Did you keep your cool and think calmly and logically?

Jon H
Posts: 125
Joined: Sun Jan 21, 2018 2:50 pm

Re: Finding the risk tolerance for AA

Post by Jon H » Wed Mar 13, 2019 11:25 am

Assuming a stock:FI allocation of 50:50 for example, are you comfortable with market volatility resulting in a reduction in your stock portion by 20%? 30%? What about 40% or more?

It helped me to think of it in terms of absolute $ reduction. So that would be $300k, $450k, or $600+k respectively. What could you tolerate? Adjust your AA accordingly.

It is entirely up to you.

The converse argument is how much portfolio growth do you need?

Again, only you can know this.
Consider gain and loss, but never be greedy and everything will be alright (fortune cookie)

stuper1
Posts: 182
Joined: Tue Apr 03, 2018 9:30 am

Re: Finding the risk tolerance for AA

Post by stuper1 » Wed Mar 13, 2019 11:41 am

I read somewhere that historically stocks have gone up on 53% of trading days and gone down on 47% of trading days, which doesn't really help you much.

If I were you, I might start at 50/50 until you've had time to fully read up and develop an investing plan (maybe you've already done that). That plan will probably have you somewhere between 20% and 80% stocks, more likely 35% to 65%. The important thing is that once you've arrived at your plan that you stick to it. This will keep you from all kinds of behavioral, market-timing problems that will cost you money. You've got plenty of money. You don't want to blow it (i.e., too much stocks), and you don't want to lose out to inflation either (i.e., too little stocks). Jack Bogle was 50/50 because half the time he felt he had too much stocks, and half the time he felt he had too little. There's nothing wrong with 50/50.

User avatar
hdas
Posts: 1236
Joined: Thu Jun 11, 2015 8:24 am

Re: Finding the risk tolerance for AA

Post by hdas » Wed Mar 13, 2019 11:56 am

StoneFeeler wrote:
Wed Mar 13, 2019 12:45 am
I understand that risk tolerance and AA ultimately boil down to one's own judgment, but how do I make the best judgment possible? Any other resources I should read or study?
Maybe read this and see if you finding actionable.
Beyond Markowitz: A Comprehensive Wealth Allocation Framework for Individual Investors
The Journal of Wealth Managment, Vol. 7, No. 4, pp 8-34, Spring 2005

28 Pages Posted: 21 Aug 2006
Ashvin B. Chhabra
Institute for Advanced Study

Abstract
In sharp contrast to the recommendations of Modern Portfolio Theory (MPT), a vast majority of investors are not well diversified. This neglect of diversification is seen across all wealth segments, including the affluent. This paper attempts to provide a solution to this "diversification paradox," by expanding the Markowitz Framework of diversifying market risk to also include the concepts of Personal Risk and Aspirational Goals.

The Wealth Allocation Framework enables individual investors to construct appropriate portfolios using all their assets, such as their home, mortgage, market investments and human capital. The investor may choose to accept a slightly lower "average rate of return" in exchange for downside protection and upside potential. The resulting portfolios are designed to meet individual investors' needs and preferences, as well as to protect individuals from Personal, Market and Aspirational risk factors.

The Wealth Allocation Framework attempts to bring together MPT with aspects of Behavioral Finance through a single pragmatic Framework. A major conclusion of this work is that, for the individual investor, Risk Allocation should precede Asset Allocation.
"whenever there is a randomized way of doing something, then there is a nonrandomized way that delivers better performance but requires more thought" ET Jaynes

KlangFool
Posts: 13956
Joined: Sat Oct 11, 2008 12:35 pm

Re: Finding the risk tolerance for AA

Post by KlangFool » Wed Mar 13, 2019 12:07 pm

OP,

It is very simple.

A) What is your current annual expense? Let's assume that this is X.

B) Make sure that your bond portion is at least 10X.

C) Pick a number between 70/30 to 30/70.

Then, you are done.

If this is too complicated for you, pick an AA of 60/40.

KlangFool

Fallible
Posts: 7012
Joined: Fri Nov 27, 2009 4:44 pm
Contact:

Re: Finding the risk tolerance for AA

Post by Fallible » Wed Mar 13, 2019 12:28 pm

StoneFeeler wrote:
Wed Mar 13, 2019 12:45 am
...
I understand that risk tolerance and AA ultimately boil down to one's own judgment, but how do I make the best judgment possible? Any other resources I should read or study?
Thanks!
To better understand risk tolerance and how an asset allocation is based on ability, willingness (risk tolerance), and need to take risk, see the wiki pages on risk tolerance and AA and their links. For further good reading, there is Rick Ferri's book, All About Asset Allocation, 2nd ed.

Here's a definition of risk tolerance from that page, which also includes information on risk questionnaires:

"Risk tolerance is an investor’s emotional and psychological ability to endure investment losses during large market declines without selling or undue worry, such as losing sleep. To know whether a portfolio is right for your risk tolerance, you need to be brutally honest with yourself as you try to answer the question, "Will I sell during the next bear market?"[1]"

https://www.bogleheads.org/wiki/Risk_tolerance
https://www.bogleheads.org/wiki/Asset_allocation
John Bogle on his early road to low-cost indexing: "When a door closes, if you look long enough and hard enough, if you're strong enough, you'll find a window that opens."

protagonist
Posts: 6013
Joined: Sun Dec 26, 2010 12:47 pm

Re: Finding the risk tolerance for AA

Post by protagonist » Wed Mar 13, 2019 1:32 pm

3 Million is a lot of money. If you are relatively frugal and don't do anything stupid you should be fine.
I would suggest a different approach than AA. This is what I do, and you have way more than enough money to do it:

1. Estimate how much money you will need for the rest of your life to maintain a lifestyle that would not cause you significant hardship (in today's dollars). Whether that amount is 10% of your total portfolio or 90% of your total portfolio is irrelevant.... put it in ultra-safe investments (like I-bonds, CDs, T-bills, etc. Right now most of mine are in 2-3 yr CDs, and as many I-bonds as I can buy annually).

2. Throw the rest in the stock market and forget about it. It's your gambling money.

If you are lucky you will get much richer. If you are unlucky and the market loses 95% of its value, you will not suffer much pain and your lifestyle won't change much- if you live too long your heirs may just have to work harder for a living. Lots of upside, little downside, and you can take all the time you are spending figuring out whether 60-40 is better than 40-60, rebalancing, recalculating, cursing your stupidity, etc....and use it to enjoy yourself with family and friends instead.

Of course, if you are one who lives beyond his/her means, this won't work for you. (But then again, nothing will).
Last edited by protagonist on Thu Mar 14, 2019 12:01 am, edited 1 time in total.

3funder
Posts: 1061
Joined: Sun Oct 15, 2017 9:35 pm

Re: Finding the risk tolerance for AA

Post by 3funder » Wed Mar 13, 2019 1:42 pm

stuper1 wrote:
Wed Mar 13, 2019 11:41 am
I read somewhere that historically stocks have gone up on 53% of trading days and gone down on 47% of trading days, which doesn't really help you much.

If I were you, I might start at 50/50 until you've had time to fully read up and develop an investing plan (maybe you've already done that). That plan will probably have you somewhere between 20% and 80% stocks, more likely 35% to 65%. The important thing is that once you've arrived at your plan that you stick to it. This will keep you from all kinds of behavioral, market-timing problems that will cost you money. You've got plenty of money. You don't want to blow it (i.e., too much stocks), and you don't want to lose out to inflation either (i.e., too little stocks). Jack Bogle was 50/50 because half the time he felt he had too much stocks, and half the time he felt he had too little. There's nothing wrong with 50/50.
+1 for a 50/50 allocation.

2015
Posts: 2906
Joined: Mon Feb 10, 2014 2:32 pm

Re: Finding the risk tolerance for AA

Post by 2015 » Wed Mar 13, 2019 2:01 pm

DonIce wrote:
Wed Mar 13, 2019 1:26 am
After having lived for 53 years, do you not have any instances in your life when you experienced some adversity that you can think back to and try to remember how you reacted to those situations? Were you emotional? Did you make irrational decisions? Did you keep your cool and think calmly and logically?
Voted: Best response.
Risk mitigation isn't something you consider in the cool, collect, calculating moment. Your historical, past relationship with risk of all kinds is the litmus test for how you will behave in the future. This is exactly why I find the "willingness, ability, need" theory so synthetic, as it is a cerebral calculation whereas risk will always be an emotional calculation.

History is replete with those who used all kinds of "calculations" during times of calm only to be completely upended during periods of absolutely terrifying market activity. Don't be one of them.

2015
Posts: 2906
Joined: Mon Feb 10, 2014 2:32 pm

Re: Finding the risk tolerance for AA

Post by 2015 » Wed Mar 13, 2019 2:05 pm

DonIce wrote:
Wed Mar 13, 2019 1:26 am
After having lived for 53 years, do you not have any instances in your life when you experienced some adversity that you can think back to and try to remember how you reacted to those situations? Were you emotional? Did you make irrational decisions? Did you keep your cool and think calmly and logically?
Voted: Best response.
Risk mitigation isn't something you consider in the cool, collect, calculating moment. Your historical, past relationship with risk of all kinds is the litmus test for how you will behave in the future. This is exactly why I find the "willingness, ability, need" theory so synthetic, as it is a cerebral calculation whereas risk will always be an emotional calculation. The Zebra having the "willingness, ability, and need" to wish he was plaid will realize he's all about the stripes when shown a mirror.

History is replete with those who used all kinds of "calculations" during times of calm only to be completely upended during periods of absolutely terrifying market activity. Don't be one of them.

pkcrafter
Posts: 13599
Joined: Sun Mar 04, 2007 12:19 pm
Location: CA
Contact:

Re: Finding the risk tolerance for AA

Post by pkcrafter » Wed Mar 13, 2019 2:07 pm

Welcome,
StoneFeeler wrote:
Wed Mar 13, 2019 12:45 am
Personal situation: Self 53 years, Wife 48 years, no other financial needs (kids provided for), trying to deploy 3 mil for 10-15 years when I expect to begin retirement and drawdown, no addition to savings expected until then.
What withdrawal rate do you need or want?
Is this a taxable account? What's in it now?
In this situation, I am trying to estimate my risk tolerance to determine the AA. I have tried various things:
1. Age in bonds: According to this, I should be 50% in bonds.

Age in bonds is so vague I don't think it's very useful at all.
2. VG risk questionnaire: This one seemed pretty generic to me. How do I know how I am going to react if there is a 20% fall in the value, etc?! Still, I went ahead and tried to best-guess it. It gave me a recommendation of 50/50.

3. I tried to study the historical drawdown charts in some websites for different allocations to help me imagine how much pain I can take. (For example: https://paulmerriman.com/fine-tuning-tables-2018/) Again the question is: how do I judge how I would react to these numbers without being in the situation?
That is the question, and you may not know the answer until you are tested under stress.

As you probably know, you have to consider need to take risk (financial), ability to take risk (financial), and willingness to take risk (emotional). You can calculate the first two, but you may not be able to figure willingness until you are under stress. When under severe stress, the fight-or-flight response may be triggered, and if it is, it is extremely hard to hold stocks. The response is instinctive and involves hormonal changes that may cause you to panic and run for safety. It is very difficult to evaluate your true willingness while in a calm, enthusiastic, mental state.

https://www.verywellmind.com/what-is-th ... se-2795194

On the other hand, some investors actually have a risk-taking gene, and those people may think this whole idea is silly.

Risk-taking gene

https://www.ncbi.nlm.nih.gov/pmc/articles/PMC2634960/
4. I tried retirement calculators such as Firecalc. According to that, if I have 3 mil at the beginning, I should be okay. But I have another 10-15 years to go before I start drawing down and I need to figure out an AA for that period.

I understand that risk tolerance and AA ultimately boil down to one's own judgment, but how do I make the best judgment possible? Any other resources I should read or study?
Read the links provided by Fallible.

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

pward
Posts: 393
Joined: Fri Dec 21, 2018 8:18 pm

Re: Finding the risk tolerance for AA

Post by pward » Wed Mar 13, 2019 2:12 pm

You have a very low need to take risk. It also sounds like you have a very low desire to take risk. So it's ok to be conservative. I would take a look at this site here. It has a bunch of unique metrics on the common model portfolios you hear people discuss here regularly. Pay especially close attention to the "heat map" where it shows the year to year performance for each start year from 1970 until today in a pretty neat and easy to read graphic, that will help you get an idea and feel of how these portfolios actually performed in the real world for actual investors, not just averages. It also has plenty of stats for max drawdown (measured by yearly close not intra-year drawdown) and time it took to get back even. You can even change to some different countries to get a feel for how the portfolios performed in different locales with different economic variables. Also, have a look down at the safe withdrawal rate calculator. Different portfolios actually have different safe withdrawal rates, and counter-intuitively the more conservative portfolios generally have a higher safe withdrawal and perpetual (never run out of money) withdrawal rate: https://portfoliocharts.com/portfolios/

Fallible
Posts: 7012
Joined: Fri Nov 27, 2009 4:44 pm
Contact:

Re: Finding the risk tolerance for AA

Post by Fallible » Wed Mar 13, 2019 3:06 pm

pkcrafter wrote:
Wed Mar 13, 2019 2:07 pm
...
On the other hand, some investors actually have a risk-taking gene, and those people may think this whole idea is silly.
Risk-taking gene
https://www.ncbi.nlm.nih.gov/pmc/articles/PMC2634960/
Thanks for posting. It adds nicely to research on genetics and willingness to take financial risks. The main points are individual differences and that prior work in this area "suggests an evolutionary explanation for our findings."

Or, for those scientists on the forum (vs. us layfolks), the '09 study states: "Our findings show that two functional polymorphisms known to regulate serotonergic and dopaminergic activity in the brain are associated with individual differences in financial risk-seeking behavior."

I think it's important that investors struggling to determine their emotional risk tolerance or to understand risk in general, realize those individual differences because it means that, in the end, it boils down to knowing themselves, leading to finding an allocation that is right for them.

OP, another good book that shows how risk tolerance changes often is Your Money & Your Brain, by WSJ columnist Jason Zweig.
John Bogle on his early road to low-cost indexing: "When a door closes, if you look long enough and hard enough, if you're strong enough, you'll find a window that opens."

User avatar
galeno
Posts: 1576
Joined: Fri Dec 21, 2007 12:06 pm

Re: Finding the risk tolerance for AA

Post by galeno » Wed Mar 13, 2019 5:28 pm

I used to be a risk junky. Then I discovered "age in bonds". At first I didn't like it. It's an acquired taste. It took me about two or three years. Now I love it.

Use a 2 fund port: 50% VT + 50% VGIT. Or split the FI into 50% VGIT + 50% TIP if you're worred about unexpected inflation hurting your FI allocation.
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 4.0%. TER = 0.4%. Port Yield = 2.82%. Term = 33 yr. FI Duration = 6.0 yr. Portfolio survival probability = 95%.

User avatar
AerialWombat
Posts: 876
Joined: Tue May 29, 2018 1:07 pm

Re: Finding the risk tolerance for AA

Post by AerialWombat » Wed Mar 13, 2019 6:00 pm

DonIce wrote:
Wed Mar 13, 2019 1:26 am
After having lived for 53 years, do you not have any instances in your life when you experienced some adversity that you can think back to and try to remember how you reacted to those situations? Were you emotional? Did you make irrational decisions? Did you keep your cool and think calmly and logically?
+1 for best answer.

When I started this journey a year ago, I thought "AA" only meant the 12-step program. Since I've never had significant capital to invest until very recently, I didn't know what my risk tolerance was. But, I sure as heck remembered what it was like in 2007-2008 when I was in chapter 7 bankruptcy and living in a van, down by the river (literally). Remembering how I felt back then, and analyzing how that experience framed my relationship with money in general, combined with the education I got from this forum and the books and other resources oft cited, gave me my AA within a few months.

It also gave me the education I needed to make decisions regarding how to take my risk in a way that satisfied certain emotional/psychological needs, but also would allow me to slightly bump returns a bit higher than a purist's 30/70 portfolio otherwise would have.

Hang out here on BH, and you will find your path.
“Life doesn’t come with a warranty.” -Michael LeBoeuf

User avatar
sergeant
Posts: 1208
Joined: Tue Dec 04, 2007 11:13 pm

Re: Finding the risk tolerance for AA

Post by sergeant » Wed Mar 13, 2019 6:04 pm

50/50 works for a lot of us. Seems like it may be right for you.

Disclosure: I'm about 35/65 right now.
Lincoln 3 EOW!

User avatar
alec
Posts: 3033
Joined: Fri Mar 02, 2007 2:15 pm

Re: Finding the risk tolerance for AA

Post by alec » Wed Mar 13, 2019 8:28 pm

StoneFeeler wrote:
Wed Mar 13, 2019 12:45 am
Personal situation: Self 53 years, Wife 48 years, no other financial needs (kids provided for), trying to deploy 3 mil for 10-15 years when I expect to begin retirement and drawdown, no addition to savings expected until then...


....But I have another 10-15 years to go before I start drawing down and I need to figure out an AA for that period.

I understand that risk tolerance and AA ultimately boil down to one's own judgment, but how do I make the best judgment possible? Any other resources I should read or study?
Yes, you should peruse several threads here by poster "bobcat2" about investing in the years leading up to retirement to ensure you continue your current standard of living financed by liability matching strategies like Social Security, Pensions, life annuities, TIPS bonds, etc.

This is much more logical and exact than various "hand wavy" measures like:

-Age in bonds.
-How you're going to reach to a 30% fall in the value of your retirement savings.
-Historical drawdown studies with portfolios based on diversification strategies (e.g. equities and nominal bonds).

I don't have time to find them now, but maybe Bob will happen by this thread and provide links to his threads. :D
"It is difficult to get a man to understand something, when his salary depends upon his not understanding it!" - Upton Sinclair

Topic Author
StoneFeeler
Posts: 26
Joined: Wed Feb 20, 2019 3:23 am

Re: Finding the risk tolerance for AA

Post by StoneFeeler » Wed Mar 13, 2019 8:34 pm

Hi all,

Thanks for all your ideas and links. I have already read some of them, but will go through the rest. I just wanted to say say that I appreciate all your help. I will pop back and share more of my thinking later.

Cheers
StoneFeeler (OP)
"Crossing the steam by feeling the stones"

Post Reply