Risk Tolerance

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Ron Scott
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Risk Tolerance

Post by Ron Scott » Mon Jun 06, 2016 5:21 am

Many people talk about "risk tolerance" as a psychological factor (Will you get nervous and sell stocks on the downturn?) but this seems odd to me. What do spouses do? Average theirs? Go with the more nervous one's splits?

Anyway....

It seems to me those who don't need all the money they have can tolerate more risk than those who live on the edge. And investing more in stocks, like the pension funds say, because you "need the return", doesn't magically get you the return you need. The less you have relative to your need the less you can risk losing it.

Other factors come into play too: availability of tax deferred accounts, tax posture overall, estate planning, etc.

I see risk tolerance as more a function of the math than our neuroses.

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Re: Risk Tolerance

Post by prudent » Mon Jun 06, 2016 5:35 am

I think in terms of "offensive risk" and "defensive risk". In the accumulation phase, I'm on offense - trying to move the ball (total assets) forward. So my risk tolerance factors in how much time I have and allows me a riskier AA (more stocks). I might have few assets at the start but I can't worry about losses since I have time on my side.

When in decumulation, I adjust to "defensive risk" - focused more on holding the line (protecting assets) so I need a more defensive strategy and less stocks in my AA.

In the big picture, I might be a relatively conservative investor in both phases, but my risk tolerance - as reflected in my AA - changes whether I'm on offense or defense.

If I had essentially an endless pile of money, I could do whatever I want. That's would be me as a professional team playing against 8th graders. My team is so strong I don't have to care what the other side does - they can't really hurt me. So I can throw long bombs (risky plays) all the time.

I know sports analogies are lame, but it's early and the coffee is slow to kick in.

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Re: Risk Tolerance

Post by magneto » Mon Jun 06, 2016 5:53 am

Academia has predominately defined Risk as Volatility; suggested by some purely for mathematical convenience?

The snag with definition of Risk as Volatility is that Risk then becomes symmetric.
I.E. There is an equal 'risk' of a gain!

What may matter to many investors is 'Downside Risk' which is asymmetric.
The higher the price paid, the greater the chance of a loss!

So we could consider other factors, such as Valuations and Redemption Timescales, when considering RiskTolerance.
'There is a tide in the affairs of men ...', Brutus (Market Timer)

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Re: Risk Tolerance

Post by joebh » Mon Jun 06, 2016 6:05 am

Ron Scott wrote:I see risk tolerance as more a function of the math than our neuroses.


If that were the case, then spouses would always have the same risk tolerance, and people in the same "mathematical circumstances" would have the same risk tolerance as each other.

That simply isn't the case.

Our background, hopes, dreams, goals, feelings about the future, experiences of the past, and our relationship with money all play a bigger part in our risk tolerance, IMHO.

Richard Thaler and Cass Sunstein talk about "Econs" versus "Humans".

For Econs, perhaps math is the dominating factor. For the rest of us, there seem to be stronger forces at play.

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Re: Risk Tolerance

Post by Fallible » Mon Jun 06, 2016 10:38 am

Ron Scott wrote:Many people talk about "risk tolerance" as a psychological factor (Will you get nervous and sell stocks on the downturn?) but this seems odd to me. What do spouses do? Average theirs? Go with the more nervous one's splits?
...
I see risk tolerance as more a function of the math than our neuroses.


The wiki's page on risk tolerance defines emotional risk tolerance, explains why it's important and why it's difficult to determine. There also are links to asset allocation and risk and reading materials: https://www.bogleheads.org/wiki/Risk_tolerance

Here is one definition of emotional risk tolerance from Rick Ferri in his book, All About Asset Allocation, 2nd ed.:

"...a measure of the amount of price volatility and investment loss you can withstand before changing your behavior. ... An emotional decision to change or abandon an investment plan as a result of market risk ultimately increases portfolio risk and reduces return. If an investor has been in a bad market long enough to lose money, that investor doesn’t want to be out of the market when it turns around. That becomes a strategy of all risk and no return."

As for couples, spouses, once each has been able to determine an individual emotional tolerance for risk,
they can work together in finding an allocation both can tolerate. Here is a forum thread on risk tolerance and note the post by "galeno."
viewtopic.php?f=10&t=192356&p=2925888#p2925888

Edit to add thread.
Last edited by Fallible on Mon Jun 06, 2016 1:21 pm, edited 2 times in total.
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Re: Risk Tolerance

Post by alex_686 » Mon Jun 06, 2016 11:06 am

Ron Scott wrote:I see risk tolerance as more a function of the math than our neuroses.


Risk tolerance can be broken down by ability and willingness.

Ability tends to be more objective and rational. Some would say mechanical and mathematical but I would lightly contest this because it rests on the ability to model the market.

Willingness tends to be more subjective and psychological. Yet even this can be reduced to a rational framework. Or, if not rational, having internally consistent logic. That being said, here is where many cognitive defects tend to creep in.

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Re: Risk Tolerance

Post by Rick Ferri » Mon Jun 06, 2016 11:38 am

There's also the "need" to take risk, or lack of a need. If you've saved enough for retirement and don't need to take a lot of risk even though your able and willing, then you may not want to expose your portfolio extra risk.

The three legs of the stool are:

"Need" to take risk is a financial formula that tells you whether you're taking enough risk or too much - your required risk level.
"Ability" to take risk measures the percentage of risk you can handle - your risk tolerance level.
"Willingness" to take risk measures the level of risk you've decided to take - your risk avoidance level.

I find the people who get in trouble put to much emphasis on their need to take risk and not enough on their ability to handle risk. It's a major flaw in advice to young people who are told to take significant risk just because they are young. If an investor fully understands their need to take risk and their ability to handle risk, then willingness comes naturally.

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Re: Risk Tolerance

Post by azanon » Mon Jun 06, 2016 1:29 pm

For me, the hardest hurdle associated with "Risk Tolerance", or that concept, is consideration of intentionally holding a portfolio with a lower expected risk-adjusted return, vs. one with a higher risk-adjusted return. More specifically, once you start getting even as high as 40% equities, every unit of risk past that point doesn't pay back an equal unit of return. And this issue is amplified the higher you go, especially north of, say, 60% equities. So, yes, I agree its a math issue, and the higher you go, you have to be willing to "pay more and more" to get "less and less".

The other issue that comes up with "Risk Tolerance", which I think (or hope) we'll see an evolution from over time, is that it's normally only talking about risk associated with equities, or operating from this notion that equities are the gold-standard asset class, and every other asset class pales in comparison to varying degrees. So as it's discussed in, say, some risk parity papers, the industry standard today, is to take almost all of your risk in stocks, and then hope for prosperity from that point forward since that is the environment in which stocks perform well, as opposed to spreading out your "risk" into other asset classes that may do poorly during prosperity, but perhaps great during unexpected inflation, or perhaps deflation even.

So all i would suggest here is, don't take a decision lightly to use a portfolio that's dominated by stocks and, therefore, is virtually guaranteed to have a lower Sharpe ratio than someone who uses more modest amounts of equities in their portfolio. Whatever analysis you choose, such as the "willingness, ability, need" one or something else, make sure you have a good reason to be using a portfolio with, say, double the expected volatility just so that you can gain an extra percent in return or so. You need a good reason, because evidence has shown that the average joe doesn't earn what the average fund makes because it is so common for individuals to take on more (equity) risk than they should have. And, besides, there are so many other alternatives to trying to make your portfolio work so hard. Save more, for example!

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Re: Risk Tolerance

Post by David Jay » Mon Jun 06, 2016 1:42 pm

Ron:

All you need to do is watch the thread titles around here when the market begins to drop. In August of last year the market dropped - what - 10% or so? Tens of "Bogleheads" were ready to bail, "sell low". Move their asset allocation to something more conservative, even go all cash.

Behavioral Finance is fascinating. Loss aversion in particular. We humans have a less-than-optimal emotional makeup.
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius

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Re: Risk Tolerance

Post by alex_686 » Mon Jun 06, 2016 1:59 pm

Rick Ferri wrote:There's also the "need" to take risk, or lack of a need. If you've saved enough for retirement and don't need to take a lot of risk even though your able and willing, then you may not want to expose your portfolio extra risk.


Rick Ferri, I have a follow up question on semantics. I have never seen the word "Need" in any of the academic or trade journals on risk tolerance.

What I have seen is a "Required Return" being generated from the investor's goals. Then required return is combined with future expected returns and risks to determine "Ability". The result is the same - it is just a formulation that I am not used to. Has the jargon shifted? Is this a easier concept to grasp for a informal setting such as Boggleheads?

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Re: Risk Tolerance

Post by Fallible » Mon Jun 06, 2016 2:24 pm

David Jay wrote:Ron:

All you need to do is watch the thread titles around here when the market begins to drop. In August of last year the market dropped - what - 10% or so? Tens of "Bogleheads" were ready to bail, "sell low". Move their asset allocation to something more conservative, even go all cash.

Behavioral Finance is fascinating. Loss aversion in particular. We humans have a less-than-optimal emotional makeup.


So true about the panic postings after a market drop and that is a big reason for the wiki's new page focusing on risk tolerance, separately from risk in general and from asset allocation. Risk tolerance is a most important basic of asset allocation, but its focus is on the individual, on knowing oneself.
https://www.bogleheads.org/wiki/Risk_tolerance

Also true about behavioral finance and loss aversion, but I would say the "less-than-optimal emotional makeup" refers to investing and money management in general. That's because of the many optimal qualities to human emotion apart from money. A good description of this is in The Bogleheads' Guide to Investing book, the chapter on "Mastering Your Investments Means Mastering Your Emotions."
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Re: Risk Tolerance

Post by galeno » Mon Jun 06, 2016 3:14 pm

Shallow risk = volatility. Deep risk = inflation.
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 3.0%. TER = 0.4%. Port Yield = 2.0%. Term = 35 yr. FI Duration = 6.2 yr. Portfolio survival probability = 100%.

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Re: Risk Tolerance

Post by Ron Scott » Mon Jun 06, 2016 3:37 pm

I like Bill Bernstein's approach to retirees which is to have a safe bucket--a stream of TIPS or an annuity for example, that will take you all the through retirement, which should be fairly sacred. And then, whatever money you have on top of that can be invested in risk assets like stocks.

If you need $40,000 from saved money, in addition to SS and pensions, you need $1,000,000 in your safe bucket. If you've got $2,000,000 you can put half in stocks. If you've got $1,500,000 put half a million in stocks, and so on.

In other words, true risk tolerance is a function of your need and your nest egg. It's just math, not a psychological concept. The "tests" just about every broker or fund manager has you take are not useful.

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Re: Risk Tolerance

Post by galeno » Mon Jun 06, 2016 5:17 pm

I love Dr Bernstein's approach ("if you've won the game why continue to play) but I don't follow it. It's a fear based approach.

To fund our retirement using Bill's philosophy we need a 40/60 port. We're a bit greedy so we us 60/40.
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 3.0%. TER = 0.4%. Port Yield = 2.0%. Term = 35 yr. FI Duration = 6.2 yr. Portfolio survival probability = 100%.

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Re: Risk Tolerance

Post by kolea » Mon Jun 06, 2016 6:13 pm

magneto wrote:Academia has predominately defined Risk as Volatility; suggested by some purely for mathematical convenience?


The cynical side of me, which by the way is my predominate side, says that volatility was called "risk" because of the nice alliterative effect - risk/reward or risk/return sounds so much better than volatility/reward. And the reason they chose volatility to pair against return is that it is easily expressed as a single, readily available metric, the standard deviation. We have now been trained to worry about volatility even though volatility does not really mean you are in danger of losing your savings.
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Re: Risk Tolerance

Post by alex_686 » Mon Jun 06, 2016 6:30 pm

kolea wrote:
magneto wrote:Academia has predominately defined Risk as Volatility; suggested by some purely for mathematical convenience?


The cynical side of me, which by the way is my predominate side, says that volatility was called "risk" because of the nice alliterative effect - risk/reward or risk/return sounds so much better than volatility/reward. And the reason they chose volatility to pair against return is that it is easily expressed as a single, readily available metric, the standard deviation. We have now been trained to worry about volatility even though volatility does not really mean you are in danger of losing your savings.


It is more than a mathematical convince. There are solid casual and logical reasons why volatility and return are linked.

Is standard deviation and volatility the same thing? No. Do lots of academics use it? Yes. It is a simple objective tool that can handle generalized situations and mostly works. Are there known issues, such as fat tails? Yes, Are there better solutions out there? For academics? The options are limited. The fat tails are hard to measure so one has to use subjective guestimates. Each market is different and each market evolves with time. At this point it turns more into a art than a science.

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Re: Risk Tolerance

Post by itstoomuch » Mon Jun 06, 2016 6:34 pm

+1,Rick Ferri
+1, Ron Scott

We made an abrupt transition from an Investment Asset Allocation model to an Income model.
Since we now have enough current and future Income that is not directly tied to equity nor to debt, I can and do swing in our discretionary investments. I am not so much risk adverse as to risk-loss avoidance. I may be near a capitulation and 're-enter the equity market after today's run up. :oops:

Disclaimers: 66/69. 4 buckets. Can live well on 2 buckets. Can draw 5%+ outside of SS, and still never deplete retirement regardless of Market on total assets less than $2mill. No bonds.
YMMV :sharebeer
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Re: Risk Tolerance

Post by pkcrafter » Mon Jun 06, 2016 7:37 pm

Discussions about risk typically go like this one. That is with posters talking past each other. That happens because individuals tend to see risk through their own lens and they have a hard time understanding someone who has a dramatically different emotional risk tolerance than their own. Ron Scott, the OP, doesn't seem to relate to emotional risk tolerance at all. I would guess he's either not experienced a bad drawdown, or he has and it didn't bother him at all because he has a very high tolerance. But that doesn't mean everyone posting in this thread sees things the same way.

What do spouses do? Good question. Typically (a rather dangerous word in finance) woman have lower tolerance levels than men do. Younger man have higher tolerances than older men, and I'm not talking about financial ability, I mean emotional risk tolerance. So, there are two areas of risk--financial ability, which can be calculated, and emotional tolerance for risk, which cannot. For some investors, it's possible to increase emotional risk tolerance with experience and understanding, but there are limits.

The first problem with emotional risk tolerance is newer investors are likely not to really know their limit. The second problem is other investors and posters have a hard time relating to someone whose limit is very different than their own. Often, a young aggressive investor may tell a new investor to go 90 or 100% stock because that's what he's doing, but it could be very bad advice if the new investor is risk averse, and even he/she may not know it.

There are many very good posts in this discussion, but the discussion itself doesn't come together because of those unique lenses through which different posters see things.

Ron Scott wrote:
I see risk tolerance as more a function of the math than our neuroses.

That's how Ron sees it and you can't argue with it. I don't see it that way at all. Ron is describing financial risk, not emotional risk tolerance, and he may dismiss emotional tolerance all together, but I'm certain other readers are very aware of emotional limits.

Ron wrote:
In other words, true risk tolerance is a function of your need and your nest egg. It's just math, not a psychological concept. The "tests" just about every broker or fund manager has you take are not useful.

Ron, I think you have to acknowledge the emotional/psychological aspect of tolerance because it does exist. There's the math, and there is the emotion, and they are usually different. It may not be a problem for you, but it is for many, if not most investors. There are some very good books on the subject if you're interested, although I'm guessing you're not. :happy

I will agree that questionnaires are not very useful because it's very difficult to determine a person's emotional limit while they are in a calm state.

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.

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Re: Risk Tolerance

Post by dbr » Mon Jun 06, 2016 7:44 pm

Paul's comments above are very good. One should note that Larry Swedroe, as best I know, is the one who originated the need/ability/willingness triad to help ordinary investors untangle the puzzle of how to allocate across more risky and less risky investments, aka stocks and bonds. Ability is specifically the mathematical part of how much risk, stated mathematically, can be taken. Willingness is precisely the psychological tolerance for risk. I think these two aspects have long been acknowledged. Need, of course, refers to what return has to be earned to meet objectives. Discussion of need vs. want is a red herring in that context.

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Re: Risk Tolerance

Post by delamer » Mon Jun 06, 2016 7:53 pm

David Jay wrote:Ron:

All you need to do is watch the thread titles around here when the market begins to drop. In August of last year the market dropped - what - 10% or so? Tens of "Bogleheads" were ready to bail, "sell low". Move their asset allocation to something more conservative, even go all cash.

Behavioral Finance is fascinating. Loss aversion in particular. We humans have a less-than-optimal emotional makeup.


In one of those many threads referred to above, someone quoted Mike Tyson:

"Everybody has a plan until they get punched in the mouth."

That truism, plus the general population's innumeracy, explains a lot. Boglehead posters are generally a step ahead when it comes to the math, at least.

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Re: Risk Tolerance

Post by Rick Ferri » Mon Jun 06, 2016 8:19 pm

alex_686 wrote:
Rick Ferri wrote:There's also the "need" to take risk, or lack of a need. If you've saved enough for retirement and don't need to take a lot of risk even though your able and willing, then you may not want to expose your portfolio extra risk.


Rick Ferri, I have a follow up question on semantics. I have never seen the word "Need" in any of the academic or trade journals on risk tolerance.

What I have seen is a "Required Return" being generated from the investor's goals. Then required return is combined with future expected returns and risks to determine "Ability". The result is the same - it is just a formulation that I am not used to. Has the jargon shifted? Is this a easier concept to grasp for a informal setting such as Boggleheads?


I'm always looking for better ways to explain complex concepts. Allan Roth calls it the complexity of finding simplicity.

When ones ability to take risk is below their need to take risk, it doesn't matter what their there willingness to take risk is, they have a problem. They're not going to have enough money. Thus, a person saving for retirement who is in this situation needs to either 1) save more each year, 2) save the same and work longer, 3) change nothing and die younger, or 4) spend less in retirement.

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Re: Risk Tolerance

Post by itstoomuch » Tue Jun 07, 2016 12:07 am

Rick Ferri wrote:
alex_686 wrote:
Rick Ferri wrote:There's also the "need" to take risk, or lack of a need. If you've saved enough for retirement and don't need to take a lot of risk even though your able and willing, then you may not want to expose your portfolio extra risk.


Rick Ferri, I have a follow up question on semantics. I have never seen the word "Need" in any of the academic or trade journals on risk tolerance.

What I have seen is a "Required Return" being generated from the investor's goals. Then required return is combined with future expected returns and risks to determine "Ability". The result is the same - it is just a formulation that I am not used to. Has the jargon shifted? Is this a easier concept to grasp for a informal setting such as Boggleheads?


I'm always looking for better ways to explain complex concepts. Allan Roth calls it the complexity of finding simplicity.

When ones ability to take risk is below their need to take risk, it doesn't matter what their there willingness to take risk is, they have a problem. They're not going to have enough money. Thus, a person saving for retirement who is in this situation needs to either 1) save more each year, 2) save the same and work longer, 3) change nothing and die younger, or 4) spend less in retirement.

Rick Ferri


But what happens when you are Close to, or In retirement? You now have lost options 1 & 2, leaving options 3 & 4, and possibly a #5. The #5 being higher yielding annuities, rentals or other income generating stuff.
YMMV :annoyed
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Re: Risk Tolerance

Post by bertilak » Tue Jun 07, 2016 2:11 pm

prudent wrote:I think in terms of "offensive risk" and "defensive risk". In the accumulation phase, I'm on offense - trying to move the ball (total assets) forward. So my risk tolerance factors in how much time I have and allows me a riskier AA (more stocks). I might have few assets at the start but I can't worry about losses since I have time on my side.

Agree, but perhaps for a different reason than you might think.

Time is on one's side when one still has exploitable "human capital." If you are generating investable income, THAT's what will save you. I think that is more important than any "reversion to the mean" argument. (If that's what you were thinking of.)

Human capital is a better portfolio risk-reducer than a bond allocation. Of course, human capital gets used up as time goes by so needs to be replaced with something. Perhaps that something is a more-than-adequately sized nest egg. Perhaps it is guaranteed income from some source outside your investment portfolio.
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Re: Risk Tolerance

Post by Rick Ferri » Tue Jun 07, 2016 7:39 pm

itstoomuch wrote:
Rick Ferri wrote:
When ones ability to take risk is below their need to take risk, it doesn't matter what their there willingness to take risk is, they have a problem. They're not going to have enough money. Thus, a person saving for retirement who is in this situation needs to either 1) save more each year, 2) save the same and work longer, 3) change nothing and die younger, or 4) spend less in retirement.

Rick Ferri


But what happens when you are Close to, or In retirement? You now have lost options 1 & 2, leaving options 3 & 4, and possibly a #5. The #5 being higher yielding annuities, rentals or other income generating stuff.
YMMV :annoyed


Possibly annuities are an answer. The downside is no inheritance to heirs. But is that really a priority when you may not have enough for yourself?

I would avoid higher yielding securities because they have price risk. An investor doesn't have to be in equity to go over thier ability to handle price risk in high yielding securities.

Rick Ferri
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Re: Risk Tolerance

Post by kolea » Tue Jun 07, 2016 8:15 pm

Rick Ferri wrote:When ones ability to take risk is below their need to take risk, it doesn't matter what their there willingness to take risk is, they have a problem. They're not going to have enough money. Thus, a person saving for retirement who is in this situation needs to either 1) save more each year, 2) save the same and work longer, 3) change nothing and die younger, or 4) spend less in retirement.

Rick Ferri


And of course the above is a good illustration of the problem with the risk narrative. Risk, as quantified by the standard deviation of the annual total return of an asset, does not say anything about how much money you will have when you retire, it only says what the uncertainty will be for annual returns. For the situation above, the person will be less likely to have the amount of savings that he/she desires upon retirement, but it is still uncertain. The person wants higher certainty and the price he/she pays for that greater certainty is less gain.

It is unfortunate that someone decided to change the meaning of variance to be risk, with all the subjectivity that goes along with that word. Statistical variance has a perfectly good, long standing interpretation as uncertainty in a value. Variance is certainly an element of risk, but the two are not equivalent, IMO.
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Re: Risk Tolerance

Post by itstoomuch » Tue Jun 07, 2016 8:28 pm

Rick Ferri wrote:
itstoomuch wrote:
Rick Ferri wrote:
When ones ability to take risk is below their need to take risk, it doesn't matter what their there willingness to take risk is, they have a problem. They're not going to have enough money. Thus, a person saving for retirement who is in this situation needs to either 1) save more each year, 2) save the same and work longer, 3) change nothing and die younger, or 4) spend less in retirement.

Rick Ferri


But what happens when you are Close to, or In retirement? You now have lost options 1 & 2, leaving options 3 & 4, and possibly a #5. The #5 being higher yielding annuities, rentals or other income generating stuff.
YMMV :annoyed


Possibly annuities are an answer. The downside is no inheritance to heirs. But is that really a priority when you may not have enough for yourself?

I would avoid higher yielding securities because they have price risk. An investor doesn't have to be in equity to go over thier ability to handle price risk in high yielding securities.

Rick Ferri

Of course of there isn't enough for retirement, there won't be anything for hurts except from an early death of the retiree.

I don't understand the second part on equity, higher yielding securities.
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Re: Risk Tolerance

Post by snarlyjack » Tue Jun 07, 2016 8:29 pm

I have a weird response to risk:

Toughen up cupcake & Toughen up bucko...
And cure your bad behavior!

Your in this for the long haul.
It works for me...

dbr
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Joined: Sun Mar 04, 2007 9:50 am

Re: Risk Tolerance

Post by dbr » Tue Jun 07, 2016 8:31 pm

kolea wrote:And of course the above is a good illustration of the problem with the risk narrative. Risk, as quantified by the standard deviation of the annual total return of an asset, does not say anything about how much money you will have when you retire, it only says what the uncertainty will be for annual returns.


Considering that how much money you will have when you retire is the compounded effect of annual returns together with contributions, the distribution from which those annual returns are produced says a great deal about what the possible distribution of end-point wealth will be. Describing such distributions can be difficult. One way to do it is to assume some possible shapes for the distribution and suppose that a couple of parameters such as the mean and standard deviation gives enough information. More sophisticated estimates require more information. Investment behavior is wild enough that things might not be able to be boiled down to precise mathematics at all. Even so, variability in annual return has a great deal to do with ultimate outcome.

A helpful illustration of the nature of the problem is here: http://www.norstad.org/finance/risk-and-time.html

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