How to know your risk tolerance, without ever living through a crash?

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neomutiny06
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How to know your risk tolerance, without ever living through a crash?

Post by neomutiny06 » Mon Jan 09, 2017 8:54 am

Many of my friends are Millennials. And I'm concerned that 100% stocks is just too aggressive for them. They don't know the hurt that may happen when the market tanks.

Furthermore, their portion in bonds should probably be split between treasuries and TIPS, because they'll need that boost up when the other part of their portfolio is going down.

Looking at Paul Merriman's fine-tuning table, http://paulmerriman.com/fine-tuning-ass ... bles-2015/ , this is a great way to look at risk tolerance. I personally know that I cannot handle losing more than half of my money. So the table says that being at 80% stocks, 20% bonds, limited the worst drawdown to 50%. That's where I should probably be.

My mother however, couldn't handle more than a 40% drop. So something like 60/40 is where the fine-tuning table would place her.

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Re: How to know your risk tolerance, without ever living through a crash?

Post by House Blend » Mon Jan 09, 2017 9:42 am

1. Don't appoint yourself as the investment guru for your friends. If someone asks you for your opinion, offer it, but otherwise keep your mouth shut. Especially if the gist of the conversation is bragging.

2. To answer the question in your title: you can't.

Make a guess as to your risk tolerance (and that's all that the Merriman table can help you with), and hope that either your guess is not too far off from reality, or else that when you eventually gain the experience, it is early enough that the damage is minimal. Perhaps a couple of down years in the stock market will be enough to wake your millenial friends up. They aren't going to learn any lessons or be open to alternatives while it is trending up.

(It took me about 20 years and recovery from the tech crash of '00-'02 before I felt that I had a good understanding of my risk tolerance.)

I'm agnostic about whether there are people for whom 100% equity is appropriate, but IMO it is totally inappropriate for anyone who is asking for advice.

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Re: How to know your risk tolerance, without ever living through a crash?

Post by dbr » Mon Jan 09, 2017 10:01 am

A point of view about risk tolerance is that once an allocation is set it is really a contract with yourself not to abandon the plan if things go to the downside. I suspect a lot of people don't really understand this commitment and why it is important to acknowledge it. Risk tolerance is as much about psychotherapy as it is about outside forces.

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Re: How to know your risk tolerance, without ever living through a crash?

Post by retire57 » Mon Jan 09, 2017 10:15 am

You don't.

It's all speculation until it happens to you and you feel the pain. (Three times for many of us in this group - 1987, 2000, 2008.)

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Re: How to know your risk tolerance, without ever living through a crash?

Post by alex_686 » Mon Jan 09, 2017 10:22 am

dbr wrote:A point of view about risk tolerance is that once an allocation is set it is really a contract with yourself not to abandon the plan if things go to the downside. I suspect a lot of people don't really understand this commitment and why it is important to acknowledge it. Risk tolerance is as much about psychotherapy as it is about outside forces.
I will extend on this. Risk tolerance can be broken down by ability, need, and willingness. The first 2 can be quantified. I have some issues with your link but it is a good start on quantifying those numbers.

Willingness on the other hand is subjective. I have seen many attempts to quantify this and I don't think any have been successful. How can you figure this out without going through a crash? 2 suggestions off of the top of my head.

How often do you look at your account? How often do you play around with it? The more often you do the less risk you can probability take in a downturn.

How do you handle stress? How do you balance short term and long term goals?

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Re: How to know your risk tolerance, without ever living through a crash?

Post by larryswedroe » Mon Jan 09, 2017 10:50 am

FWIW, my 20+ years experience as an advisor has demonstrated that the academic research showing that overconfidence is an all too human trait (in all endeavors) certainly applies to investing. So that means that it's likely that investors who have not lived through a bear market will overestimate their ability to stomach the losses when it actually happens, and thus they take too much equity risk.

My experience has also taught me that you get far different answers when you talk in absolute dollar amounts rather than %. So someone is more likely to say that they can take a 40% loss without panicking and selling than they would say that with a 1mm equity portfolio and it has just lost 400,000 and now you need to buy more to rebalance to say yes they would do that. So how you frame the problem matters a lot. You can help people by framing it in dollar terms, not percentages

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Re: How to know your risk tolerance, without ever living through a crash?

Post by JW-Retired » Mon Jan 09, 2017 10:53 am

neomutiny06 wrote: Many of my friends are Millennials. And I'm concerned that 100% stocks is just too aggressive for them. They don't know the hurt that may happen when the market tanks.
Not sure how it helps them know their risk tolerance, but I guess Paul Merriman's "fine-tuning table" might help them imagine what could very easily happen.

But I think maybe you are being unimaginative in trusting that Merriman's table, which goes back to only 1970, gives a reasonable worst case. In the US far worse than the 2008/09 recession has happened. In the Great Depression the DOW dropped 90% between the peak in 1929 and the bottom in 1931. Going by that 90% equities drop, if you really and truly can't handle losing more than half your investment money then you should not go above about 55% stocks. Plus you should not sell your bonds to re-balance into stocks during a crash.

Not to say Millennials shouldn't take the risk and be in 80% stocks, but you are probably kidding yourself if you think the Merriman table derived 50% is the worst drawdown you will ever see.
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Re: How to know your risk tolerance, without ever living through a crash?

Post by rkhusky » Mon Jan 09, 2017 11:20 am

Another thing to keep in mind about risk tolerance in a crash is that the drop in stock prices does not occur in a vacuum. There is usually other things going on in the world, like wars and economic collapse of companies and industries, such that all the "experts" and talking heads fear that the entire stock system will collapse and many of your stocks will be worthless.

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Re: How to know your risk tolerance, without ever living through a crash?

Post by neomutiny06 » Mon Jan 09, 2017 1:39 pm

House Blend wrote:1. Don't appoint yourself as the investment guru for your friends. If someone asks you for your opinion, offer it, but otherwise keep your mouth shut. Especially if the gist of the conversation is bragging.

2. To answer the question in your title: you can't.

Make a guess as to your risk tolerance (and that's all that the Merriman table can help you with), and hope that either your guess is not too far off from reality, or else that when you eventually gain the experience, it is early enough that the damage is minimal. Perhaps a couple of down years in the stock market will be enough to wake your millenial friends up. They aren't going to learn any lessons or be open to alternatives while it is trending up.

(It took me about 20 years and recovery from the tech crash of '00-'02 before I felt that I had a good understanding of my risk tolerance.)

I'm agnostic about whether there are people for whom 100% equity is appropriate, but IMO it is totally inappropriate for anyone who is asking for advice.
Is there a better chart to use than Paul Merriman's? I would like to see the worst drawdown that I might experience by being say 80/20.

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Re: How to know your risk tolerance, without ever living through a crash?

Post by Cyclesafe » Mon Jan 09, 2017 2:43 pm

When the market "drops 40%", or whatever, one still has the same number of shares distributed among the same companies. Nothing changes.

When one exchanged cash for equities one has equities, not cash. Always thinking about equities in terms of the dollars they would bring - even when one hadn't intended to sell these equities for decades - is a grave mistake.

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Re: How to know your risk tolerance, without ever living through a crash?

Post by Fallible » Mon Jan 09, 2017 2:45 pm

neomutiny06 wrote:Many of my friends are Millennials. And I'm concerned that 100% stocks is just too aggressive for them. They don't know the hurt that may happen when the market tanks.

Furthermore, their portion in bonds should probably be split between treasuries and TIPS, because they'll need that boost up when the other part of their portfolio is going down.

Looking at Paul Merriman's fine-tuning table, http://paulmerriman.com/fine-tuning-ass ... bles-2015/ , this is a great way to look at risk tolerance. I personally know that I cannot handle losing more than half of my money. So the table says that being at 80% stocks, 20% bonds, limited the worst drawdown to 50%. That's where I should probably be.

My mother however, couldn't handle more than a 40% drop. So something like 60/40 is where the fine-tuning table would place her.
Risk tolerance is difficult to determine because it is basically about knowing oneself, which is never easy. The differences you note between you and you mother are good examples of how deeply personal and individual emotional tolerance is. Also, holding through one crash doesn't guarantee you can in the next one because crashes differ in nature and length, and one's personal circumstances will differ over time.

There is much written about risk tolerance and a place to start is the Wiki page on "Risk Tolerance" with links and references to some of the best books and blogs on the subject.
https://www.bogleheads.org/wiki/Risk_tolerance
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A "real" bear market

Post by Taylor Larimore » Mon Jan 09, 2017 3:03 pm

Is there a better chart to use than Paul Merriman's? I would like to see the worst drawdown that I might experience by being say 80/20.
neomutiny:

The worst bear market I have endured was the 1929-1932 when the Dow plunged 89%. You can read what it was like from this earlier post of mine:

Taylor Larimore| 09-28-00

Our family owned "Larimore's Diner" in Foxboro, Mass. in 1929. I was 5 years old and remember. When the depression hit, we lost the Diner and moved into my grandfather's home in Miami. Grandfather, who was an investor and chief executive of an investment trust company, lost everything--including the Miami home we lived in.

These figures show what a REAL bear market is like:

BEAR MARKET OF 1929-1937 (Dow plunged 89%)
-1929--1930--1931--1932
(-31%)(-25%)(-43%)(-08%) Large Cap Stocks
(-34%)(-35%)(-47%)(-06%) Mid/Small Cap Stocks
(-47%)(-38%)(-50%)(-05%) Micro Cap Stocks

(+04%)(+07%)(-02%)(+09%) 5-Year Treasury Bonds

BEAR MARKET OF 1973-1976 (S&P fell 43%)
-1973--1974
(-15%)(-26%) Large Caps
(-39%)(-29%) Micro Caps

---(-70%) Coca-Cola
---(-82%) Intel
---(-73%) McDonald's
---(-86%) Merrill Lynch
---(-86%) Walt Disney
---(-71%) Xerox

Figures cannot convey the horrifying and debilitating effects of a bear market. You watch in agony as month after month your life savings evaporate before your eyes. Gloom and doom talk is everywhere. Nearly everyone else is selling. You have no idea when, or if, your portfolio will stop losing money.

Your friends and relatives urge you to sell.. Nearly all financial experts recommend "sell". You are ridiculed for trying to hold on. You begin to have self-doubt. Despair sets in. Buying stocks is unthinkable. Suicide's increase. That's a REAL bear market
Best wishes.
Taylor
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Re: How to know your risk tolerance, without ever living through a crash?

Post by nedsaid » Mon Jan 09, 2017 3:09 pm

How would somebody who never has been through a bear market measure their risk tolerance? I don't think that is knowable. In October 1987, the Dow 30 crashed by 22% in one day. I lost hundreds of dollars and it seemed like billions. No kidding. There was no frame of reference for me as I had never been through something like that before.

I went into the 2000-2002 bear market with an 80% stock and 20% bonds and cash portfolio. My losses peak to trough were about 32%. Kept what I had and I just kept investing. The 2008-2009 bear market was tougher to take as it was coupled with a financial crisis that could have become a second Great Depression. That was really scary but I hung on knowing that if I sold that I would never meet my retirement objectives. I went into the 2008-2009 at about 72% stocks and 28% bonds and cash. My losses were about 34% that time.

I also found that my risk tolerance increased during bull markets and decreased during bear markets. During the bear markets, my though process was pretty much "what was I thinking?" Bull markets had me wondering if I was aggressive enough.

If a millennial investor isn't sure about risk tolerance, I would suggest a 60% stock/40% bonds balanced portfolio. It is a good portfolio for most anyone. I would err on the side of conservatism.
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Re: How to know your risk tolerance, without ever living through a crash?

Post by Quark » Mon Jan 09, 2017 3:22 pm

Risk tolerance has two meanings - psychological and economic. Be careful not to ignore the economic aspects.

There could easily be circumstances in which you need to use your portfolio to pay necessary expenses at a time when it's down substantially, even though you have the psychological fortitude to stay the course.

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Re: How to know your risk tolerance, without ever living through a crash?

Post by nisiprius » Mon Jan 09, 2017 3:40 pm

Cyclesafe wrote:When the market "drops 40%", or whatever, one still has the same number of shares distributed among the same companies.
Yes.
Nothing changes.
Something has changed. Investors no longer believe these companies are going to earn as much or pay out as high dividends as before. To say that nothing changes is to say that when you crash a car, nothing changes--you had a 2015 Honda Accord before the crash and you have a 2015 Honda Accord after the crash.

The situation is very different between my house and my stocks. I use my house personally as shelter and it has much the same value to me if the market value drops. But the only reason I own stocks is to get a financial return. They have no non-financial function.
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Re: How to know your risk tolerance, without ever living through a crash?

Post by auggiedoggies » Mon Jan 09, 2017 3:53 pm

I honestly have no idea what my risk tolerance is, simply because I've never lived through a crash (I'm in my mid to late 20's).

In lieu of experience, I try to supplement with knowledge. I have studied and read, and I believe that at my age, I need to be as aggressive as possible. Hence, between my Roth IRA and 401K (~100k) I am 100% in stocks (Vanguard index funds of course) and my wife's 401K (25K) is the same. I also have as much of my HSA invested as possible.

Is this foolhardy? Perhaps. How would I react to a 40% downturn? I have no idea. But I have convinced myself that logically, this is the best way to acquire wealth. Am I wrong?

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Re: How to know your risk tolerance, without ever living through a crash?

Post by Fallible » Mon Jan 09, 2017 4:27 pm

nedsaid wrote:How would somebody who never has been through a bear market measure their risk tolerance? I don't think that is knowable. ...
I doubt that emotional risk tolerance is, or ever will be, precisely measurable, but I think it is knowable to some extent depending on how well one is in touch with one's self, with one's emotions. At least that is how I see it after 30 years investing in funds, beginning in April '87, months before the October crash. I had stayed in CDs until then, holding off investing in the market until I had a chance to read more about stocks and felt I understood market risk well enough to invest in a mutual fund. That feeling was most likely my risk tolerance, but it also was my risk tolerance telling me to hold off in the first place until I better understood what I was getting into.

Thus, I knew something of my risk tolerance before a crash and I did hold, even though the crash showed me I had much more to learn for the long term.
Last edited by Fallible on Mon Jan 09, 2017 4:44 pm, edited 1 time in total.
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Re: How to know your risk tolerance, without ever living through a crash?

Post by Cyclesafe » Mon Jan 09, 2017 4:41 pm

nisiprius wrote:
Cyclesafe wrote:When the market "drops 40%", or whatever, one still has the same number of shares distributed among the same companies.
Yes.
Nothing changes.
Something has changed. Investors no longer believe these companies are going to earn as much or pay out as high dividends as before. To say that nothing changes is to say that when you crash a car, nothing changes--you had a 2015 Honda Accord before the crash and you have a 2015 Honda Accord after the crash.

I get and appreciate your point, but your analogy could be better. Perhaps rather than being left with a permanently damaged car, one is left with a broken arm that will heal and become a memory as you continue to live and reach your potential. (Or you could die of an infection). :)

The situation is very different between my house and my stocks. I use my house personally as shelter and it has much the same value to me if the market value drops. But the only reason I own stocks is to get a financial return. They have no non-financial function.

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Re: How to know your risk tolerance, without ever living through a crash?

Post by Dirghatamas » Mon Jan 09, 2017 4:50 pm

neomutiny06 wrote:Many of my friends are Millennials. And I'm concerned that 100% stocks is just too aggressive for them. They don't know the hurt that may happen when the market tanks.
I am much older (46) but this post brought back memories of 1990s and the Tech Boom/Crash. In the early nineties, I was the only person in my circle of friends who was a passive investor and on top of that globally, passive investment instead of US home bias. Indexing was crazy and globally on top of that was double crazy. Mutual funds were for old retired people!

Being young, I remember arguing about this passionately with my friends. We didn't change any views. All my friends invested in a very small handful of "Hot" US Technology companies. They all made a bunch of money (paper money) in the mid to late nineties and then lost it all in 2000-2002 Tech Crash. None of the advice I gave at the time was of any use.

My input to you would be to talk to your friends about how you invest and why but don't expect most to change behavior. We all need to make our own mistakes and learn from them. Second hand lessons seldom work.

As for risk tolerance, it is unknowable till you have been through MULTIPLE bear markets. Anyone who claims they know their brains well enough is fooling themselves.
As the famous philosopher Mike Tyson once said : "Everybody has a fight plan till they get punched in the mouth". :sharebeer

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Re: How to know your risk tolerance, without ever living through a crash?

Post by JW-Retired » Mon Jan 09, 2017 7:15 pm

neomutiny06 wrote: Is there a better chart to use than Paul Merriman's? I would like to see the worst drawdown that I might experience by being say 80/20.
Well, starting with an 80/20 $100k portfolio, and using the worst Great Depression drawdown as a guide, the $80k in stocks drops to $8k. If the $20k in bonds holds their value you would have $28k left from your $100k at the bottom.

Don't know of a "better chart", but any chart going back to 1928 would have this 90% stock loss as the worst case drawdown in it. But sorry, nobody can say if even this is the worst you might experience in the future.
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Re: How to know your risk tolerance, without ever living through a crash?

Post by David Jay » Mon Jan 09, 2017 7:27 pm

I think a big portion of it is your own commitment - do you understand enough about how/why you have invested the way you have to "defend" your investment strategy to yourself during the downturn.
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Re: How to know your risk tolerance, without ever living through a crash?

Post by dbr » Mon Jan 09, 2017 7:33 pm

David Jay wrote:I think a big portion of it is your own commitment - do you understand enough about how/why you have invested the way you have to "defend" your investment strategy to yourself during the downturn.
+1

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Re: How to know your risk tolerance, without ever living through a crash?

Post by Toons » Mon Jan 09, 2017 7:45 pm

Your initial investment in a mutual fund is 100k
You watch it decline in value Slowly,
like chinese water torture for almost 2 years,
to 60,000 or less
The above can happen,and has happened,,,to me.
1.Do you steady buy those two years
2.Are you paralyzed with indecision and do nothing,and hold.
3 .Do you,in your attempts to 'salvage' what you have left,,sell.

If you can truthfully answer those questions ,
then you will get a pretty good feel for your risk tolerance...truthfully.

By the way ,I chose to do number 1. :mrgreen:
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Re: How to know your risk tolerance, without ever living through a crash?

Post by pkcrafter » Mon Jan 09, 2017 8:00 pm

neomutiny, as I see it, the market could drop 20-25% and you would be OK. But what caused it to drop in the first place? It's always the same reason, investors are selling. They sell based on news or an unexpected event, or simply because everyone else is selling in panic mode. Initial selling has a hair trigger. Following that, a second tier of investors begin to sell because they see the market dropping. It creates a chain reaction with little thought. Get out NOW and think about it later.

Now, in your case you would watch the market drop from 25% to 35% and you'd say, OK, I expected that. Then when the drop continues to 45% or 50% and still continues down, you suddenly find yourself in deep water, no life preserver, no plan, no control. People hate the feeling of not being in control, and they want to fix it ASAP. The only way is to get rid of the stuff that's creating the pressure. For most of us, it's very scary (Taylor's post), and selling is what happens. And it is all because other investors are selling their stocks and it's contagious.

OK, a bit dramatic, but I don't know why Merriman sets a limit on how much the market can drop when we know for certain it can drop much more than 50%. To be fair, there are some investors that can ride out what the market hands out, but it's limited to maybe 10-15% who carry the right genes. The rest are fooling themselves. '29 doesn't matter we might say because things have changed and that can't happen again. Well, in the tech crash, the NASDAQ lost 78%, so yes, it can happen again. Being thrown into a lake without knowing how to swim is not the time to try and learn.

Or, as Fred Schwed put it..
On the emotions of losing money: “Like all of life’s rich emotional experiences, the full flavor of losing important money cannot be conveyed by literature. You cannot convey to an inexperienced girl what it is truly like to be a wife and mother. There are certain things that cannot be adequately explained to a virgin by words or pictures.”
It's far better to take a little less risk and not sell, then to try for higher returns and fail.
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: How to know your risk tolerance, without ever living through a crash?

Post by Daryl » Mon Jan 09, 2017 8:15 pm

I'm 33, so I really don't have a lot of experience with "crashes". Through 2008-2009, I was buying equities at a discount! The subsequent bull market has been very good. I keep about 2 times my annual salary in equities, which means I've been buying a lot of fixed income investments. I could probably increase my equities to 3 times my salary, but my savings rate is fairly high, and I don't need the risk. I'll be retiring early regardless of what equities do!

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Re: How to know your risk tolerance, without ever living through a crash?

Post by ray.james » Mon Jan 09, 2017 8:51 pm

Also, realize there are 2 elements to the crash:
1) The raw drop in value of assets aka the Crash
2) The time it takes to fall and recover back.

A number of people can see what the first factor does to their portfolio. So they change bonds ratio or even think they can ride it out. It is the assumptions on the second one that I often see people get wrong. They underestimate the time it takes to recover and do not consider the personal circumstances, pain/anguish from loss, prolonged job loss with bleak outlook or their career might just be unscathed. Because of this, I have decided to err on the side of caution with my retirement funds.
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Re: How to know your risk tolerance, without ever living through a crash?

Post by darkhorse346 » Mon Jan 09, 2017 8:56 pm

I think it makes more sense to look at the amount of money one could potentially be down instead of the percentage.

Investor A is 30 and has $50K in retirement savings. S(he) experiences a 50% decline. Not pleasant, but the account is down to $25K and s(he) has 35 more years to invest.

Investor B is 60 and has $1M in retirement savings. S(he) experiences a 50% decline and now has $500K in retirement. Life altering in a bad way to say the least.

Read a lot of the Bill Bernstein threads. There is one circulating on the BH forum now that would be very good for you to digest.

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Re: How to know your risk tolerance, without ever living through a crash?

Post by Fallible » Mon Jan 09, 2017 9:03 pm

OP, you might find this previous forum thread on risk tolerance by pro Boglehead Rick Ferri of some help, in particular his article on age-based allocation and young investors. He also links to a paper by Meir Statman and Carrie Pan on "risk tolerance, regret, overconfidence, and other investor propensities," with the Abstract showing why risk tolerance can be difficult to determine:

viewtopic.php?t=104985
https://papers.ssrn.com/sol3/papers.cfm ... id=1549912
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Re: How to know your risk tolerance, without ever living through a crash?

Post by Dandy » Tue Jan 10, 2017 10:10 am

I think many can accept a very high risk when starting out because the assets in question are usually relatively small. For example they may have 20k and feel that a 50% loss is very tolerable. They can easy make up that loss in contributions (and company matches) in a few years. But, they may fail to take the dollar loss into account when their portfolio gets a lot larger - say 300k in their 30's and the loss is 150k. That might take a decade or so on contributions/matches to make up - and they would be in their 40's. (I putting aside equity market growth just for illustration). The way it might "feel" is I had 300k and now I have 150k and I'm 30's and if I continue to save I could be in my 40's before I get back - I am basically now tied to the equity market my contributions and matches are not the driver to success.

I think age and dollar loss vs percentage loss is a key to understand risk.

I remember in 2008 just retired and lost about 25% of my conservative portfolio I got a nice wake up call that percentages seem less scary than dollar losses -- especially because when large dollar losses occur there are usually a lot of other bad things happening e.g. job losses, inability to sell a house, inflation, low interest rates, companies stop matching 401ks, no raises or bonuses,etc. If you are a boglehead type investor and experience a 50% loss you can bet there are a lot of other bad things happening.

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Re: How to know your risk tolerance, without ever living through a crash?

Post by TravelerMSY » Tue Jan 10, 2017 6:39 pm

Agree. Scale matters in the scariness of declines. It's very easy to be 100% in equities when you're young and working and your net worth is low. And some amount of magical thinking in which they consider their retirement plans not really part of their assets because it can't easily be spent now.

But once it gets up into the six and seven figures, it starts looking like real money pretty quickly.

What seems odds to me is people avoiding bonds, even when the risk-adjusted return of a mix of stocks and bonds is higher than that of stocks alone. Probably because it results in a lower absolute return and retirement accounts aren't easily levered.

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