Need, ability and willingness to take risk

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Calm Man
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Need, ability and willingness to take risk

Post by Calm Man » Sun Jan 05, 2014 11:17 am

A concurrent thread has caused me to make this post, which I have thought about for quite a while. I would love it if somebody could point out where I am incorrect in my thoughts. I don't need who came up with the concept of "need, ability and willingness" to take risk. I believe either Rick Ferri or Larry Swerdroe (or both) use it frequently. But I wish it would be reduced to 2 variables and not 3. Because I think that need and ability are simply mirror images, while willingness is clearly distinct.

The commenters even in this post (I think Kevin was one) say thing like: if you have a billion dollars you have zero need to take risk and 100% ability to take risk. I propose that need + ability = 100% if one had a way of scoring. Or put another way, they are inversely related. Please tell me where I am wrong here with a single illustration as I would like to be shown to be wrong since I am challenging conventional wisdom.

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VictoriaF
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Re: Need, ability and willingness to take risk

Post by VictoriaF » Sun Jan 05, 2014 11:24 am

The problem is with defining the word "need." Take someone in his early 60s with $300k in his 401(k). He has high "need" to take risk within his 401(k) to have a hope of a reasonable retirement; but he has low "ability" to take risk, because, well, it's risky and he may lose $100k-$150k. Using your formula, let's assume that his need = 90%, and his ability = 10%.

So what is the meaning of his "need"? Does it imply that he MUST take risk? That he SHOULD take risk, if he also has "willingness"?

Victoria
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Re: Need, ability and willingness to take risk

Post by dbr » Sun Jan 05, 2014 11:39 am

Need means what are your objectives and ability means what harm comes to you if risk shows up.

A person whose objectives outrun his means has a high need to take risk and also low ability to take risk. Unless that investor reduces his objectives or increases his means, he is screwed.

A person whose means outrun his objectives has low need to take risk and also high ability to take risk. A rule to resolve that is the rule to take no more risk than necessary. A perspective on the problem is that the marginal utility of wealth diminishes with increasing wealth and that there is a tendency to underestimate risk (these concepts courtesy of Larry Swedroe).

Someone else can figure out what kind of financial circumstances would constitute low need and also low ability to take risk and high need and high ability to take risk.

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VictoriaF
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Re: Need, ability and willingness to take risk

Post by VictoriaF » Sun Jan 05, 2014 11:52 am

dbr wrote:Need means what are your objectives and ability means what harm comes to you if risk shows up.

A person whose objectives outrun his means has a high need to take risk and also low ability to take risk. Unless that investor reduces his objectives or increases his means, he is screwed.
...
Someone else can figure out what kind of financial circumstances would constitute low need and also low ability to take risk ...
If that investor reduces his objectives to make them comparable to his low ability to take risk, then he will have low need and low ability. The formula would then be

Need + Ability << 100%

But what if he also has high "willingness"?

Victoria
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Re: Need, ability and willingness to take risk

Post by TheTimeLord » Sun Jan 05, 2014 11:56 am

Calm Man wrote:A concurrent thread has caused me to make this post, which I have thought about for quite a while. I would love it if somebody could point out where I am incorrect in my thoughts. I don't need who came up with the concept of "need, ability and willingness" to take risk. I believe either Rick Ferri or Larry Swerdroe (or both) use it frequently. But I wish it would be reduced to 2 variables and not 3. Because I think that need and ability are simply mirror images, while willingness is clearly distinct.

The commenters even in this post (I think Kevin was one) say thing like: if you have a billion dollars you have zero need to take risk and 100% ability to take risk. I propose that need + ability = 100% if one had a way of scoring. Or put another way, they are inversely related. Please tell me where I am wrong here with a single illustration as I would like to be shown to be wrong since I am challenging conventional wisdom.
http://www.forbes.com/sites/afontevecch ... ankruptcy/

Forbes valued the Brazilian billionaire at $30 billion in early 2011, as Batista himself predicted he would soon become the richest man in the world, leaving Carlos Slim Helu, Bill Gates, and Warren Buffett in the dust.
His personal fortune has been decimated by the spectacular decline in his companies’ stock prices, going from $30 billion to less than $1 billion.
OGX filed for bankruptcy protection in Rio de Janeiro, disclosing total debt worth 11.2 billion reais, or about $5.11 billion. Of those, $3.6 billion are owed to bondholders, most of them foreign, according to Dealbook.
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Re: Need, ability and willingness to take risk

Post by Bungo » Sun Jan 05, 2014 12:04 pm

It seems to me that someone in his 20s with zero money but a lifetime of earning capacity ahead of him has both 100% need and 100% ability to take risk.

A retired guy with no savings of his own but a good pension might have 0% need and 0% ability to take risk.

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Re: Need, ability and willingness to take risk

Post by VictoriaF » Sun Jan 05, 2014 12:08 pm

StarbuxInvestor wrote:Forbes valued the Brazilian billionaire at $30 billion in early 2011, as Batista himself predicted he would soon become the richest man in the world, leaving Carlos Slim Helu, Bill Gates, and Warren Buffett in the dust.
His personal fortune has been decimated by the spectacular decline in his companies’ stock prices, going from $30 billion to less than $1 billion.
Batista had low need, high ability and high willingness. In his case, the "willingness" was higher than his "ability" and became the determining factor. He had something like:
Need = 1%
Ability = 99%
Willingness = 150%

It seems that "ability" is the primary factor of the three. And this presents two polar scenarios.

[EDIT] the reset of this message is replaced by a later message.

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Re: Need, ability and willingness to take risk

Post by TheTimeLord » Sun Jan 05, 2014 12:08 pm

Bungo wrote:It seems to me that someone in his 20s with zero money but a lifetime of earning capacity ahead of him has both 100% need and 100% ability to take risk.
Until someone has some padding in their finances, an emergency fund, I do not believe they have a high ability to take risk because of the possible consequences when combined with real world events like job loss, divorce or children.
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Re: Need, ability and willingness to take risk

Post by dbr » Sun Jan 05, 2014 12:18 pm

VictoriaF wrote:
dbr wrote:Need means what are your objectives and ability means what harm comes to you if risk shows up.

A person whose objectives outrun his means has a high need to take risk and also low ability to take risk. Unless that investor reduces his objectives or increases his means, he is screwed.
...
Someone else can figure out what kind of financial circumstances would constitute low need and also low ability to take risk ...
If that investor reduces his objectives to make them comparable to his low ability to take risk, then he will have low need and low ability. The formula would then be

Need + Ability << 100%

But what if he also has high "willingness"?

Victoria
Willingness means having the ability to manage psychologically when risk shows up. Specifically this means a person with a high stock allocation who does not panic and sell everything at the bottom of a market crash. Not having willingness, like taking no more risk than needed, trumps any tendency to take risk even if ability is high. Willingness to take risk does not trump low ability to take risk.

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Re: Need, ability and willingness to take risk

Post by Bungo » Sun Jan 05, 2014 12:19 pm

StarbuxInvestor wrote: Until someone has some padding in their finances, an emergency fund, I do not believe they have a high ability to take risk because of the possible consequences when combined with real world events like job loss, divorce or children.
Yeah, fair enough. I'll amend that to "someone in his 20s with an adequate emergency fund but no other savings."

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Re: Need, ability and willingness to take risk

Post by bcjb » Sun Jan 05, 2014 12:35 pm

So high human capital + adequate emergency fund + minimal current savings --> high need & high ability.
I think this applies to most 20-somethings; it can't be a very unusual combination.

I think I understand "need" and "ability", but the one that baffles me is "willingness". The consensus on this site is that it's almost impossible to know your true willingness to take risk until you are in the middle of a crisis. How is it then actionable? Should new (post-2008/9) investors just assume a low willingness to take risk until they find out otherwise?

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Re: Need, ability and willingness to take risk

Post by stlutz » Sun Jan 05, 2014 12:44 pm

I think the slight difference relates to the fact that "ability" is related to ones current circumstances--how much surplus to I have right now, while need is related to ones future requirements.

So, consider the 40 year old who has a million dollars saved and adds another 50K per year. He wants to retire by age 50 and have two homes--one in Hawaii and the other in Aspen. He has a high ability and high need to take risk in this rubric.

Alternatively, consider the person who is 62, has $100,000 saved, and lives a modest lifestyle. Social security and small pension will be sufficient to cover his expenses in retirement. He has a low need and a low ability to take risk.

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Re: Need, ability and willingness to take risk

Post by Calm Man » Sun Jan 05, 2014 12:47 pm

Folks, you guys have helped me understand it, starting with Victoria. It indeed took me awhile to internalize it. Very simply, let us take somebody, anybody who is in solid shape to do whatever he/she wants. For this average person, my original statement likely applies: high ability to take risk, low need. But dial up the desires or objectives. Suddenly this person wants to buy a mansion and they can't. So their need goes way up. And their ability can likely be argued to stay the same or similar (although I guess that could be disputed).

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Re: Need, ability and willingness to take risk

Post by larryswedroe » Sun Jan 05, 2014 12:53 pm

FWIW Don't know if anyone else ever used it before but I started using that over 15 years ago when wrote my first book
Need and ability are very different

Ability is based on a few things
A) your horizon, the longer the more you can wait out a bear market
B) the stability of your labor capital and how it correlates to the risks of stocks
c) the percentage of your labor capital relative to the financial assets

Need is entirely different and totally unrelated

Need is the rate of return you need to achieve your goals--whatever they may be. Of course as you convert desires (nice to haves) into needs your need to take risk increases, and vice versa. The marginal utility of wealth plays a big role here

Willingness is simply the stomach acid or sleep well test--how much of a drop can you take and still REBALANCE, let alone not panic.

This is discussed in great detail in The Only Guide to Right Financial Plan
Larry

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Re: Need, ability and willingness to take risk

Post by dbr » Sun Jan 05, 2014 12:55 pm

bcjb wrote:So high human capital + adequate emergency fund + minimal current savings --> high need & high ability.
I think this applies to most 20-somethings; it can't be a very unusual combination.

I think I understand "need" and "ability", but the one that baffles me is "willingness". The consensus on this site is that it's almost impossible to know your true willingness to take risk until you are in the middle of a crisis. How is it then actionable? Should new (post-2008/9) investors just assume a low willingness to take risk until they find out otherwise?
For the beginning investor bailing out in panic at the bottom of a market is probably not of fatal consequence. That permanent loss of some savings will be made up with future earnings and savings invested more wisely.

For older investors I would say there is no doubt that the single most fatal mistake that can be made as an investor is to have too much invested in stocks and to permanently lose much of that investment by selling out in a panic at the bottom of a major crash.* Of course, there is still the risk that, having not sold out, the market does not recover in time to help, but that contingency comes under the ability heading.

There is also an important consideration here in specifying what it is that is at risk. Market volatility is one thing while ability to fund retirement is another thing. It comes back to the old observation that risk of running out of money in retirement is not very sensitive to asset allocation except that the risk rises substantially if one does not have enough in stocks. It is also apparent, or should be, that insuring income in retirement would utilize more tools than simply allocating a portfolio, meaning SS, pensions, annuities, etc., etc.

*Actually there is one worse thing, which is to reinvest what is left at the top of a market cycle and repeat the process.

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Re: Need, ability and willingness to take risk

Post by Sriracha » Sun Jan 05, 2014 1:03 pm

Here's the way the wiki reduces Larry's risk tolerance framework re: ability, need and willingness:

"Ability to take risk involves investment time horizon, liquidity needs, stability of earned income, and the flexibility to adapt if the portfolio does not achieve its expected returns (i.e., "plan B").

Willingness to take risk is characterized as the eat well/sleep well trade-off. Taking more risk is required to enable the possibility of higher expected returns (eat well). However, if investors take more risk than they are emotionally able to handle, then it is likely that they will abandon their investment plans if their portfolios suffer sufficiently severe losses. So it is unwise for investors to take so much risk that they will be unable to sleep well during the inevitable stock market downturns.

Need to take risk is related to the investment goal. If the goal requires a higher expected return, the investor needs to take more risk with the expectation that doing so will result in a higher return. Perhaps more importantly, once the investor has "won the game" by accumulating sufficient wealth, it is unwise to take more risk than is needed, since the value of additional gains is much less important than the consequences of severe losses."

http://www.bogleheads.org/wiki/Risk_and ... _take_risk

I can sort of see what the OP means regarding a relationship between ability and need, but I think it's important to note that Larry intends for investors to approach each of those from a totally different perspective, as described above, and together those perspectives cover the waterfront for those 2 axes of risk tolerance (or that axis -- if you find it easier to consider them one).

Personally, I like the three pronged approach b/c it makes sense to me to weigh my need to take risk as one risk tolerance element, uncluttered by all of the other separate considerations included under the ability segment. If it makes sense for you to combine them, that's cool too as long as all of the individual elements Larry enumerates are considered.
Last edited by Sriracha on Sun Jan 05, 2014 6:16 pm, edited 1 time in total.
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Re: Need, ability and willingness to take risk

Post by VictoriaF » Sun Jan 05, 2014 1:28 pm

Larry has invented the concept of "need, ability and willingness" and provided detailed definitions that are cited above. But it's easier to deal with simpler concepts such as those provided by dbr:
dbr in different messages wrote:
  • - Need means what are your objectives.
    - Ability means what harm comes to you if risk shows up.
    - Willingness means having the ability to manage psychologically when risk shows up.
I'd like simplify it even further:
  • - Need = how much money I need to have the lifestyle I want
    - Ability = how much money I have
    - Willingness = how much risk I am willing to take
"Ability," i.e., how much money I have, is the determining factor. Below, are the two scenarios on the opposite sides of the "ability" spectrum:

1. Low ability (little money)
If I have little money, i.e., "low ability," it means that I need to make a lot of money to afford what I want, i.e., "high need." Either I have to find some means to satisfy my high need, or I have to scale down my need. In the latter case, it becomes:

low ability + low need << 100%

2. High ability (a lot of money)

high ability + low need = 100%

But now "willingness" becomes a critical factor:
- Low willingness results in a conservative portfolio, focused on the capital preservation.
- High willingness leads to using a risky portfolio. Usually, the decision to use a risky portfolio is made well before a severe risk shows up, and one may overestimate the strength of his stomach.

Well-off ("high-ability") investors should have:
willingness < ability
or
willingness + need < 100%

Victoria
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Re: Need, ability and willingness to take risk

Post by littlebird » Sun Jan 05, 2014 1:32 pm

larryswedroe wrote:
Willingness is simply the stomach acid or sleep well test--how much of a drop can you take and still REBALANCE, let alone not panic.

Larry
I think the scope of "willingness" is larger than that. I DID sleep well AND rebalanced (and then some) into stocks in '87, 2001 and 2008-9. But I have now reached an age where I am simply unwilling to carry more equity risk than 100 minus my age. I have the ability, I even have some need to provide for long term care should I reach very old age, but I don't have the "willingness" any more.

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Re: Need, ability and willingness to take risk

Post by Leif » Sun Jan 05, 2014 1:44 pm

I thought of it differently. I thought ability related to how stable was your income. If you have a stable income such as teacher or doctor your income is pretty stable. If you are a salesman then probably less so. I thought of need is how much risk is needed to make your goals. Wiliness I thought of is as guts or can you keep your calm while everyone is losing theirs and stick with your plan. A lot of people over estimate their wiliness until the markets teaches them their true wiliness. It can be an expensive lesson.
Last edited by Leif on Sun Jan 05, 2014 1:51 pm, edited 1 time in total.
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Re: Need, ability and willingness to take risk

Post by cfs » Sun Jan 05, 2014 1:51 pm

Leaders, good morning/afternoon/evening

Thanks for asking. I have read all of Larry's books and I am well aware of the definitions. I don't know of any other author using the trifecta. We have Larry's post above with his very own definitions. I will go with Larry's definitions on the trifecta. For me, capital preservation is paramount--I no longer have the ability, need, nor willingness for extra risk--long live the SWAN.

Thanks for reading.
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Re: Need, ability and willingness to take risk

Post by dbr » Sun Jan 05, 2014 2:08 pm

VictoriaF wrote:Larry has invented the concept of "need, ability and willingness" and provided detailed definitions that are cited above. But it's easier to deal with simpler concepts such as those provided by dbr:
dbr in different messages wrote:
  • - Need means what are your objectives.
    - Ability means what harm comes to you if risk shows up.
    - Willingness means having the ability to manage psychologically when risk shows up.
I would like to add a note to this. My understanding and advocacy of this concept comes directly from being educated about it by Larry. I am very reluctant to think of improving or simplifying what Larry has written on this. I am also quite prepared to be called to account if I have misrepresented Larry's ideas, though to the best of my intentions I have not done that. I do strongly recommend reading Larry's own discussion at full length in his book The Only Guide to a Right Financial Plan I do agree that the meaning of the ideas is not necessarily self evident in a mere three words.

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Re: Need, ability and willingness to take risk

Post by YDNAL » Sun Jan 05, 2014 2:24 pm

Calm Man wrote:I don't need who came up with the concept of "need, ability and willingness" to take risk. I believe either Rick Ferri or Larry Swerdroe (or both) use it frequently. But I wish it would be reduced to 2 variables and not 3.
I agree, and personally feel that "willingness" is strictly psychological and not measurable with actual personal financial metrics. That said, we all know whether we have:
  • "Need" (or not) based on our savings, personal goals, and timeframe.
  • "Ability" (or not based on personal levels of secured income streams.
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Re: Need, ability and willingness to take risk

Post by larryswedroe » Sun Jan 05, 2014 2:53 pm

cfs
If you have already won the game, why are you still playing is one of my favorite expressions and one I ask of many high net worth people I consult with who still have high equity allocations, which indicate a high marginal utility of wealth
larry

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Re: Need, ability and willingness to take risk

Post by Calm Man » Sun Jan 05, 2014 3:25 pm

larryswedroe wrote:FWIW Don't know if anyone else ever used it before but I started using that over 15 years ago when wrote my first book
Need and ability are very different

Ability is based on a few things
A) your horizon, the longer the more you can wait out a bear market
B) the stability of your labor capital and how it correlates to the risks of stocks
c) the percentage of your labor capital relative to the financial assets

Need is entirely different and totally unrelated

Need is the rate of return you need to achieve your goals--whatever they may be. Of course as you convert desires (nice to haves) into needs your need to take risk increases, and vice versa. The marginal utility of wealth plays a big role here

Willingness is simply the stomach acid or sleep well test--how much of a drop can you take and still REBALANCE, let alone not panic.

This is discussed in great detail in The Only Guide to Right Financial Plan
Larry
Wow. Thank you Larry. Indeed I had NOT been considering time horizon in ability at all and it looks like most of the others omitted it too.

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Re: Need, ability and willingness to take risk

Post by dbr » Sun Jan 05, 2014 3:29 pm

Calm Man wrote: Wow. Thank you Larry. Indeed I had NOT been considering time horizon in ability at all and it looks like most of the others omitted it too.
You mean like when I said this:

"For the beginning investor bailing out in panic at the bottom of a market is probably not of fatal consequence. That permanent loss of some savings will be made up with future earnings and savings invested more wisely."

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Re: Need, ability and willingness to take risk

Post by Calm Man » Sun Jan 05, 2014 3:30 pm

larryswedroe wrote:cfs
If you have already won the game, why are you still playing is one of my favorite expressions and one I ask of many high net worth people I consult with who still have high equity allocations, which indicate a high marginal utility of wealth
larry
What do they say?

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Re: Need, ability and willingness to take risk

Post by Calm Man » Sun Jan 05, 2014 3:31 pm

dbr wrote:
Calm Man wrote: Wow. Thank you Larry. Indeed I had NOT been considering time horizon in ability at all and it looks like most of the others omitted it too.
You mean like when I said this:

"For the beginning investor bailing out in panic at the bottom of a market is probably not of fatal consequence. That permanent loss of some savings will be made up with future earnings and savings invested more wisely."
That is why I said most. Thanks for the correction dbr.

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.....

Post by pinecrest » Sun Jan 05, 2014 6:08 pm

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Re: Need, ability and willingness to take risk

Post by larryswedroe » Sun Jan 05, 2014 7:36 pm

Calm man
They are simply overconfident in most cases, an all too human condition, and made worse by their success in creating wealth
They also treat the unlikely as impossible
Larry

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Re: Need, ability and willingness to take risk

Post by cfs » Sun Jan 05, 2014 8:13 pm

larryswedroe wrote:cfs
If you have already won the game, why are you still playing is one of my favorite expressions and one I ask of many high net worth people I consult with who still have high equity allocations, which indicate a high marginal utility of wealth
larry
Larry, thanks. Recommendation acknowledged. Because my "need" right now is on capital preservation, I will work on lowering my equity allocation starting this week. Again, thanks for the advise.
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Re: Need, ability and willingness to take risk

Post by TheTimeLord » Sun Jan 05, 2014 8:37 pm

larryswedroe wrote:cfs
If you have already won the game, why are you still playing is one of my favorite expressions and one I ask of many high net worth people I consult with who still have high equity allocations, which indicate a high marginal utility of wealth
larry
So let me play devil's advocate here. Isn't winning actually reaching an aspirational goal. I mean there are quite a few people here who I am willing to bet have combined SS and Pension benefits that are close to 1.5X - 2X the median income in America. That by itself is winning. And some have on top of that high 6 or low 7 figure portfolios which no one is telling them should be 100% bond I don't think. I guess what I am saying is at some point we aspire to some standard of living and security which when reached seems to mean you won. But if you reach it say 10 or 15 years earlier than expected is it wrong to aspire to something more?
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Re: Need, ability and willingness to take risk

Post by hudson » Sun Jan 05, 2014 8:39 pm

LarrySwedroe said this about taking risk in August 2012. I bookmarked this link to his comments.

http://www.bogleheads.org/forum/viewtop ... 2#p1372822

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Re: Need, ability and willingness to take risk

Post by bobcat2 » Sun Jan 05, 2014 8:58 pm

From the viewpoint of financial economics you have risk capacity (close to what Swedroe calls ability) and risk tolerance (what Swedroe calls willingness) and that risk capacity takes precedence. Briefly your risk capacity consists of objective measures of your risk profile such as do you have a lot of debt, do you have a secure job, do you have substantial human capital, do you have a reserve or emergency fund, are you healthy, do you own or rent, if you own is the mortgage paid, etc. Risk tolerance is how you feel about risk and plays a secondary role. If you don't have the risk capacity, it doesn't matter how risk tolerant you are, you don't have the capacity to take on risk. For example, a 59 year old individual who is determined to retire no later than age 63 has little risk capacity because she has so little remaining human capital. Therefore, her high risk tolerance is irrelevant, because she has little remaining risk capacity.

Instead of thinking in terms of need to take risk, keep in mind the following. If you are falling short of your retirement income goal there are only three ways to improve the chances of getting there: Save more (and consume less) now, work longer (retire later), or take more risk (and accept a larger shortfall in the event you do not succeed). To assert that you have a “need” to accept a larger shortfall makes little sense to me personally or financial economists in general.

In the book Risk Less and Prosper by Zvi Bodie and Rachelle Taqqu most of chapter 6 is devoted to explaining these concepts.

BobK
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Re: Need, ability and willingness to take risk

Post by pkcrafter » Sun Jan 05, 2014 10:33 pm

Ah, yet another thread on trying to understand risk. Good, I look forward to these.

I think need to take risk is best understood when thinking of the returns over 30 years in so called safe investments vs stocks. In fact, safe investments are not safe, they are very risky when one realizes goals cannot be met with safe investments.

dbr wrote:
"For the beginning investor bailing out in panic at the bottom of a market is probably not of fatal consequence. That permanent loss of some savings will be made up with future earnings and savings invested more wisely."
It may be true that an investor can still come out Ok if he bails; however, a bail out loss is permanent and cannot be recovered. Also, you not only lose the principle, you lose the compounding. Bailing is bad--it converts shallow risk to deep risk permanent loss.

dbr wrote:
Willingness to take risk does not trump low ability to take risk.
I agree.

Bobcat wrote:
From the viewpoint of financial economics you have risk capacity (close to what Swedroe calls ability) and risk tolerance (what Swedroe calls willingness) and that risk capacity takes precedence. Briefly your risk capacity consists of objective measures of your risk profile such as do you have a lot of debt, do you have a secure job, do you have substantial human capital, do you have a reserve or emergency fund, are you healthy, do you own or rent, if you own is the mortgage paid, etc. Risk tolerance is how you feel about risk and plays a secondary role.
I would agree that capacity should trump tolerance, but in the real world it isn't likely to happen. Rational decision making flies out the window when emotions take over, and that's what happens if risk tolerance is exceeded. Risk averse investors are risk averse regardless of whether capacity is high or not. I do think that risk tolerance can be increased with a better understanding and experience in bear markets.

Good thread.

Paul
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Re: Need, ability and willingness to take risk

Post by larryswedroe » Sun Jan 05, 2014 11:06 pm

StarbuxInvestor
It's all about defining what is "enough" and the marginal utility of wealth. Here's my favorite story on subject
Author Kurt Vonnegut related this story about fellow author Joseph Heller: “Heller and I were at a party given by a billionaire on Shelter Island. I said, ‘Joe, how does it make you feel to know that our host only yesterday may have made more money than your novel Catch-22 has earned in its entire history?’ Joe said, ‘I’ve got something he can never have.’ And I said, ‘What on earth could that be, Joe?’ And Joe said, ‘The knowledge that I’ve got enough.’”

Sure you can change your definitions of enough over time----along with your ability and willingness and need to take risk changing with circumstances as well. It's all very personal and only you can make the decision.
One key is to not have desires or nice to haves become needs to have and another is to understand what is truly important in life----and I would add that the key issue I try to teach all about taking risks is that the consequences of your decisions should dominate whatever you think the probabilities of the outcomes are.

These are all areas where a good financial advisor can help to educate and help to find the right answer.

I hope that is helpful
Best wishes
Larry

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Re: Need, ability and willingness to take risk

Post by countdown » Sun Jan 05, 2014 11:15 pm

Great Joseph Heller story...love it.

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Re: Need, ability and willingness to take risk

Post by bobcat2 » Sun Jan 05, 2014 11:24 pm

pkcrafter writes.
I think need to take risk is best understood when thinking of the returns over 30 years in so called safe investments vs stocks. In fact, safe investments are not safe, they are very risky when one realizes goals cannot be met with safe investments.
Once more time. If you are falling short of your retirement income goal there are only three ways to improve the chances of getting there: Save more (and consume less) now, work longer (retire later), or take more risk (and accept a larger shortfall in the event you do not succeed).

Safe investments have known outcomes. If those known outcomes are below your goals, you do not lower risk by taking a chance on an even lower outcome, perhaps significantly lower. By taking more risk in this situation you get a shot at making your goal, but at the cost of possibly falling much further below your goal. :(

Safe investments should be used to finance important goals that must be met with high probability. For example, your floor income goal in retirement (your minimum acceptable level of retirement income) should be funded with safe assets. If you are unable to finance your floor level of income with safe assets then the probability of meeting your floor income goal will not be nearly as high as you undoubtedly would like it to be.

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Re: Need, ability and willingness to take risk

Post by pkcrafter » Mon Jan 06, 2014 1:02 am

Bob, I don't see where we are in disagreement. Yes, you may need to hold some safe investments, but when investors are just starting out they need to understand that they have a very low probability of reaching a retirement sum that will sustain them unless they take on stock risk. Holding all so-called safe investments for 30 years will not get the job done. So, from the standpoint of meeting a retirement goal, it's more risky to hold only CDs and bonds than it is to hold a good portion of stocks.

Paul
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Re: Need, ability and willingness to take risk

Post by bobcat2 » Mon Jan 06, 2014 9:42 am

pkcrafter wrote:Bob, I don't see where we are in disagreement. Yes, you may need to hold some safe investments, but when investors are just starting out they need to understand that they have a very low probability of reaching a retirement sum that will sustain them unless they take on stock risk. Holding all so-called safe investments for 30 years will not get the job done. So, from the standpoint of meeting a retirement goal, it's more risky to hold only CDs and bonds than it is to hold a good portion of stocks.

Paul
We disagree because to some degree you are setting up a strawman IMO. No one is advocating investing only in safe assets. The only time anyone should invest only in safe assets for a goal many years away is when they are very risk averse and their goal can be met by investing only in safe assets.

I think part of the confusion here is that those who advocate for a safe floor typically begin assessing their investment strategy by asking how close to my goal do I get, if I were to invest only in safe assets. That first step allows them to see how short of their goal they fall while taking minimum risk. They then add risk to the point where they can reach their goal. If that is more risk than they want to take either because it exceeds their risk capacity or their risk tolerance, they must save more or postpone the timing of the financial goal, or lower the goal. However, starting the assessment with all safe assets is not the same as advocating one should only invest in safe assets even though that will leave you significantly short of your goal.

It also seems to me that describing over investing in safe assets as risky, because you may fall short of your goal, is peculiar and inconsistent. If that is risky, then it is also true that not saving more is risky and not postponing retirement is risky. Yet I never hear anyone say unwillingness to postpone retirement is risky. Yet that unwillingness is "risky" in the same sense that over investing in safe assets is "risky". It seems to me we don't describe unwillingness to postpone retirement as risky because it is not really a risk, but instead a decision we make about reaching our goals. The same is true of how we invest in safe assets.

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Re: Need, ability and willingness to take risk

Post by TheTimeLord » Mon Jan 06, 2014 9:48 am

I come from the school of thought that one of the most valuable things in investing is idea generation. You don't use every idea you here but you try to consider and understand them. This thread has been very interesting for me from that perspective.
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Re: Need, ability and willingness to take risk

Post by IlliniDave » Mon Jan 06, 2014 9:50 am

I don't think need and ability are on the same continuum. Both are difficult to quantify.

Risk is also multi-dimensional in and of itself. Capital fluctuation versus inflation are the primary ones, and guarding against one usually results in exposure to the other. They project differently onto need and ability.

All is predicated on having enough resources to meet some criteria, but that exact value is unknown as future needs are unknown.

Putting all that together, the "need, ability, and willingness" space is a confusing one. Need and ability may not be completely orthogonal, but they're not coincident either.

I tend to operate based on just ability and willingness in midlife. Later need may overshadow ability. At this stage I'd rather strike out swinging than looking.
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Re: Need, ability and willingness to take risk

Post by Doc » Mon Jan 06, 2014 10:48 am

Bungo wrote:It seems to me that someone in his 20s with zero money but a lifetime of earning capacity ahead of him has both 100% need and 100% ability to take risk.

A retired guy with no savings of his own but a good pension might have 0% need and 0% ability to take risk.
Maybe this hits the "ability" question on the head.

I suggest that his ability is zero because he has no money to risk. :idea:

Hey Goggle is a wonderful thing.

First hit:
While your willingness for risk may be vague, your ability to take risk is quantifiable. It is based on your budget ...
http://theincidentaleconomist.com/wordp ... -and-need/
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Re: Need, ability and willingness to take risk

Post by bobcat2 » Mon Jan 06, 2014 11:19 am

Bungo wrote:
StarbuxInvestor wrote: Until someone has some padding in their finances, an emergency fund, I do not believe they have a high ability (risk capacity) to take risk because of the possible consequences when combined with real world events like job loss, divorce or children.
Yeah, fair enough. I'll amend that to "someone in his 20s with an adequate emergency fund but no other savings."
You haven't amended it enough. In addition to not having an emergency fund people in their 20s typically have lots of other reasons why their risk capacity is low. Most young people (at least 90%) have credit card, auto, and often student loan debt, or even worse payday loans and their ilk, and at the same time insecure jobs and career paths, i.e. most young people don't have much risk capacity. :(

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Re: Need, ability and willingness to take risk

Post by Rodc » Mon Jan 06, 2014 1:38 pm

Need is the rate of return you need to achieve your goals--whatever they may be. Of course as you convert desires (nice to haves) into needs your need to take risk increases, and vice versa. The marginal utility of wealth plays a big role here
This has always bothered me greatly.

While of course Larry knows better it is far too easy for many to read that as if you take more risk you will get more return. If you truly need X dollars and failing to have it is a big deal you should not attempt to get there by taking more risk, especially very high risk. You need to save more, work longer, etc. Otherwise it is merely a desire for more return not a plan for more return.

If "need" makes any sense it has to come last. You have to decide on ability to handle risk first and foremost. Next you can decide the upper limit to the amount of risk you are willing to take on up to but not over your ability to be ok if the risk shows up. After that the amount of return you "need" can be considered to adjust in the range up to but not over ability and willingness. And in particular if you will be fine and happy with a smaller return than suggested as hopeful by ability and willingness one should consider moving risk down rather than maxing risk to ability and willingness.

Personally I think while need and ability are very different as Larry notes, in fact they are inversely related as suggested by the OP at least to the extent that as ability goes up due to having more money (in hand or future income) the less one needs in returns to meet ones basic needs.

But personally I would leave need out and work with ability and willingness. Given the level of risk suggested simply plan how much to save each paycheck based on a reasonable estimate of future returns.
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Re: Need, ability and willingness to take risk

Post by Fallible » Mon Jan 06, 2014 2:09 pm

bobcat2 wrote:
pkcrafter wrote:Bob, I don't see where we are in disagreement. Yes, you may need to hold some safe investments, but when investors are just starting out they need to understand that they have a very low probability of reaching a retirement sum that will sustain them unless they take on stock risk. Holding all so-called safe investments for 30 years will not get the job done. So, from the standpoint of meeting a retirement goal, it's more risky to hold only CDs and bonds than it is to hold a good portion of stocks.

Paul
We disagree because to some degree you are setting up a strawman IMO. No one is advocating investing only in safe assets. The only time anyone should invest only in safe assets for a goal many years away is when they are very risk averse and their goal can be met by investing only in safe assets.

I think part of the confusion here is that those who advocate for a safe floor typically begin assessing their investment strategy by asking how close to my goal do I get, if I were to invest only in safe assets. That first step allows them to see how short of their goal they fall while taking minimum risk. They then add risk to the point where they can reach their goal. If that is more risk than they want to take either because it exceeds their risk capacity or their risk tolerance, they must save more or postpone the timing of the financial goal, or lower the goal. However, starting the assessment with all safe assets is not the same as advocating one should only invest in safe assets even though that will leave you significantly short of your goal.
...
BobK
If by risk averse you're referring to risk tolerance, then wouldn't risk tolerance be as important or more so than financial capacity? If a new investor has the financial means to invest but not the emotional tolerance for the stocks needed to achieve his/her goals, isn't it better for an advisor to suggest at least starting out with a lower stock allocation to lessen the chance the client will suffer sleepless nights and/or panic and bail out in bad markets? Isn't the main goal, the bottom line, to craft an AA that will allow the investor to stay the course even if it requires a longer term to meet his goals?
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Re: Need, ability and willingness to take risk

Post by pkcrafter » Mon Jan 06, 2014 2:50 pm

Bob k and Rodc,

The example of need to take risk I used above is, I think, one of the few clear examples of need. Larry defines it this way:
Need is the rate of return you need to achieve your goals
Of course the rate of return can be modified by adjusting the goal, but I believe it's still a clear example. In all but the rarest of cases, a young investor has a need to take stock risk in order to achieve the goal of having enough to retire.

Wade Pfau and William Bernstein point out that asset classes with lower expected returns are riskier in the long term, and they are since they cannot provide the needed return.
Because of inflation, bonds become riskier than stocks over long horizons
http://wpfau.blogspot.com/2013/11/willi ... allow.html

When we bring in different and unusual definitions of risk we tend to confuse the whole issue. An no wonder we can't ever have a discussion on risk that settles the argument and makes everyone happy. Just consider this from John Norstad article on risk and time:

To summarize, simple probability of shortfall is an inadequate measure of risk because it fails to take into account the magnitudes of the possible shortfalls and gains. When we attempt to correct this simple measure of risk by taking the magnitudes into account, we are led to utility theory, which tells us that there is no absolute sense in which we can claim that risk either increases or decreases with time horizon. All it tells us is that it depends on the individual investor, his current wealth, and his risk tolerance patterns as expressed by his particular utility function. For some investors, in this model we can say that risk increases with time. For others, risk decreases with time. For still others, risk is independent of time.

http://www.norstad.org/finance/risk-and-time.html


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Re: Need, ability and willingness to take risk

Post by bobcat2 » Mon Jan 06, 2014 3:48 pm

Hi Paul,

You don't 'need' a certain rate of return to reach your goals. You could reach your goals by saving more each year or postponing retirement for several years. Do you then have a 'need' to save more per year or a 'need' to work more years?
Need is the rate of return you need to achieve your goals.

How about
Need is the age you must work to in order to achieve your goals.


or

How about
Need is the amount you must save each year to achieve your goals.
Aren't the latter two 'needs' just as valid as the first 'need'? Then why don't you write posts about the 'need' to work to a ripe old age?

Real bonds do not become riskier over time because of inflation. I doubt Pfau said they do. If he did, he is wrong. In fact held to maturity real bonds are the safest long term asset.

Utility functions deal with our risk averson (or risk tolerance). For example, consider the CRRA class of utility functions, where CRRA stands for constant relative risk aversion. A CRRA utility function says our risk aversion does not change, even though our levels of wealth and consumption change. Utility functions have nothing to say about whether risk is increasing or decreasing or staying the same over time. An investor with a CRRA utility function would be decreasing his risk exposure if risk were increasing over time, but increasing his risk exposure over time if risk were decreasing, everything else held constant. Of course, it is rarely the case that everything else stays constant. :happy

Your worries seem to be focused on a nearly non-existent problem. I don't see many posts here where young investors only want to invest in safe assets. I do see a lot of posts here about young people who want to invest in 100% stocks. It's amazing what a year of 30% equity returns will do for the risk tolerance of young investors. And, at least in their minds, it appears to be also able to markedly increase their risk capacity. :D

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Re: Need, ability and willingness to take risk

Post by Rodc » Mon Jan 06, 2014 4:07 pm

Paul,

The challenge is that one had better not need more than about what you can get from bonds because that might be about all you get. A plan for much more than that is really more a wish. A reasonable wish perhaps, but still a wish.

I would say a young person has no idea what return they need because the future is so uncertain. They have no clue what they will need for income in 50 years. Or what they will earn over the decades in income or investment returns. I agree that most young people should have a decent amount of stocks because historically (and reasonably expected in the future) that will pay off well, but not because they can specify some particular expected needed return. You start with a reasonable generic portfolio if you are a reasonably generic person and watch what happens. If all goes well, great, replan every 10 years or so and all is good. If things do not go well, you start trying to save more and/or plan to work longer, you don't increase your "needed" return (which is just a mental trick to tell yourself to take more risk). Same really at some level for most people of any age, subject to the ability and willingness to bear the risk.

As soon as one starts with a statement like I need a specific return of (real) 4% they are in trouble. They can get there if they get the historical mean returns from a 60/40 portfolio, but they might also get much less. I guess part of my concern is summed up in my signature line: anyone who thinks they can specify a specific return and engineer a portfolio with some specific level of risk to hit that specific return to plus or minus some small tolerance has no clue how investing works.

I guess that is another significant part of my objection: you simple cannot start with a return target and engineer a portfolio to hit it. And that to my mind is what the need part of need, willingness and ability suggests or likely suggests to many. Far better to my mind is using willingness and ability to build your portfolio and then assess the likely range of outcomes and make a plan where you will be fine if you end up on the low side (may be hard to make a plan that works in the very worst case, but then that is pretty true of much of life.)
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Re: Need, ability and willingness to take risk

Post by bobcat2 » Mon Jan 06, 2014 4:21 pm

Fallible wrote:[W]ouldn't risk tolerance be as important or more so than financial capacity? If a new investor has the financial means to invest but not the emotional tolerance for the stocks needed to achieve his/her goals, isn't it better for an advisor to suggest at least starting out with a lower stock allocation to lessen the chance the client will suffer sleepless nights and/or panic and bail out in bad markets? Isn't the main goal, the bottom line, to craft an AA that will allow the investor to stay the course even if it requires a longer term to meet his goals?
No. Nearly all young people are constrained by their risk capacity. Most young people (at least 90%) have credit card, auto, and often student loan debt, or even worse payday loans and their ilk, insecure jobs and career paths, and little or no emergency funds, i.e. most young people don't have much risk capacity. Given how wide spread constrained risk capacity is, and also the fact that it is easier to measure, we start with risk capacity.

Also moving out of stocks when the going gets rough is not necessarily that harmful, despite endless claims to the contrary. Suppose you were 80% stocks when you bailed to 20% after the Lehman collapse in September of 2008. The market would drop nearly 40% more before hitting bottom in March 2009. So someone holding their stock allocation would have to have stocks appreciate 80% from the bottom to stay even with you. If you went back to 80% stocks after the market rallied 50% you would be well ahead of the investor who held his position. Or consider the Japanese 80/20 investor who 'panicked' in the early 1990s. She would be about three times as well off today as the 80/20 Japanese investor who stayed the course.

OTOH if you have a lot of debt, no emergency fund, and get laid off you are in a world of hurt that gets hugely worse if your portfolio crashes at the same time. That is a "for sure" problem caused by low risk capacity. :(

BobK
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Re: Need, ability and willingness to take risk

Post by richard » Mon Jan 06, 2014 4:33 pm

pkcrafter wrote:Bob k and Rodc,

The example of need to take risk I used above is, I think, one of the few clear examples of need. Larry defines it this way:
Need is the rate of return you need to achieve your goals
Of course the rate of return can be modified by adjusting the goal, but I believe it's still a clear example. In all but the rarest of cases, a young investor has a need to take stock risk in order to achieve the goal of having enough to retire.
The problem with taking more risk is that it is riskier. You can easily find yourself further from your goal when the risk manifests.

There are no guarantees that you will be rewarded for taking more risk, even if you hold for a very long time.

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