Psychological vs. Real Risk

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Ron Scott
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Psychological vs. Real Risk

Post by Ron Scott » Fri Oct 12, 2018 10:07 am

Using asset allocation to manage volatility and downside risk is a standard BH tenet.

Psychological risk is what most financial writers spend their time on, i.e., the risk that someone's fear or nerves or whatever will cause them to sell equities unnecessarily at a low. Determining your psychological tolerance to risk requires some combination of experience and introspection, and of course becomes increasingly complex given an involved spouse with a different tolerance level. One oddity with the construct is it's ostensible constancy: One supposedly doesn't change one's tolerance level (with resultant changes in AA) much over time, as this story is told. There's a messiness to it but it is intuitive and most seem to come to terms with it.

Real risk (my ineloquent label as I forget what others call it) can be defined as the need to sell equities at a low for living expenses. Determining real risk is more mathematical in nature, combining information about your asset allocation, spending needs, breadth and duration of market downturns, to estimate what percentage of your portfolio would be sold low and how that will affect your financial position going forward. This involves running some scenarios with different assumptions about the market drop, duration, spending, etc. Not as messy as psychological risk, but still messy. The extreme example: A retiree with 100% equities would always be selling stock to live and therefore would be selling in downturns at lows by definition. Other slightly less aggressive investors would be able to hold out selling stocks for some months before they are forced to do so.


This raises 3 questions:

1. Would it be a good rule of thumb to maintain an AA by setting the percentage in equities to the lower of your psychological and real risk assessments?

2. Should one actively work on reducing or eliminating psychological intolerance to risk as defined above and simply address real risk?

3. Is the your-age-in-bonds recommendation a reasonable approach to handling all this in a more robust way (greater tolerance to volatility) without all the bother?
Retirement is a game best played by those prepared for more volatility in the future than has been seen in the past. The solution is not to predict investment losses but to prepare for them.

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galeno
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Re: Psychological vs. Real Risk

Post by galeno » Fri Oct 12, 2018 1:31 pm

I prefer #3 but "lumpy". Assume retirement at age 60.

Start 80/20 until age 50. 60/40 until age 60. 40/60 after that.
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 4.0%. TER = 0.4%. Port Yield = 2.82%. Term = 33 yr. FI Duration = 6.0 yr. Portfolio survival probability = 95%.

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Re: Psychological vs. Real Risk

Post by livesoft » Fri Oct 12, 2018 1:36 pm

1. I don't think so. Almost every time someone loses big money, they worry a little bit or at least get a little bit uncomfortable. So if they set their AA to the lower of Psych or Real, then they will still feel the desire or wish not to lose money.

And there is another side to this. It is not just that they won't sell when they hit a lower band, but will they BUY to rebalance. I often read on the BH.org forum where someone says "I didn't sell", but they didn't buy either when they probably should have bought.
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KlangFool
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Re: Psychological vs. Real Risk

Post by KlangFool » Fri Oct 12, 2018 1:40 pm

livesoft wrote:
Fri Oct 12, 2018 1:36 pm
1. I don't think so. Almost every time someone loses big money, they worry a little bit or at least get a little bit uncomfortable. So if they set their AA to the lower of Psych or Real, then they will still feel the desire or wish not to lose money.

And there is another side to this. It is not just that they won't sell when they hit a lower band, but will they BUY to rebalance. I often read on the BH.org forum where someone says "I didn't sell", but they didn't buy either when they probably should have bought.
+1.

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Re: Psychological vs. Real Risk

Post by chevca » Fri Oct 12, 2018 1:47 pm

I think the OP makes sense, but it's sort of over complicated, IMO.

If one "needs" to sell equities for living expenses, they better have lots of $$ in equities or not have money needed for living expenses in equities. Shoot, even bond funds can go down. Of course, not as much as stock funds can go down. Living expense money should probably be kept in the bank, so it's nice and safe. Keep some in stock, some in bonds, and pull a year or three years or whatever of living expense money out of whichever is doing better at the time. Keep it simple.

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Re: Psychological vs. Real Risk

Post by marcopolo » Fri Oct 12, 2018 1:57 pm

livesoft wrote:
Fri Oct 12, 2018 1:36 pm
1. I don't think so. Almost every time someone loses big money, they worry a little bit or at least get a little bit uncomfortable. So if they set their AA to the lower of Psych or Real, then they will still feel the desire or wish not to lose money.

And there is another side to this. It is not just that they won't sell when they hit a lower band, but will they BUY to rebalance. I often read on the BH.org forum where someone says "I didn't sell", but they didn't buy either when they probably should have bought.
This is a very good point. I remember selling bonds to buy more stock several times during the 2008/2009 recession. It was very painful, and I questioned my own sanity quite often. I think some of the people cheering for a big crash either did not live through that, or have forgotten how difficult it was to follow through on rebalancing, which sounds great in theory, but can be very difficult to stick to in times like that.
Once in a while you get shown the light, in the strangest of places if you look at it right.

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Re: Psychological vs. Real Risk

Post by Artsdoctor » Fri Oct 12, 2018 3:32 pm

Ron Scott wrote:
Fri Oct 12, 2018 10:07 am
Using asset allocation to manage volatility and downside risk is a standard BH tenet.

Psychological risk is what most financial writers spend their time on, i.e., the risk that someone's fear or nerves or whatever will cause them to sell equities unnecessarily at a low. Determining your psychological tolerance to risk requires some combination of experience and introspection, and of course becomes increasingly complex given an involved spouse with a different tolerance level. One oddity with the construct is it's ostensible constancy: One supposedly doesn't change one's tolerance level (with resultant changes in AA) much over time, as this story is told. There's a messiness to it but it is intuitive and most seem to come to terms with it.

Real risk (my ineloquent label as I forget what others call it) can be defined as the need to sell equities at a low for living expenses. Determining real risk is more mathematical in nature, combining information about your asset allocation, spending needs, breadth and duration of market downturns, to estimate what percentage of your portfolio would be sold low and how that will affect your financial position going forward. This involves running some scenarios with different assumptions about the market drop, duration, spending, etc. Not as messy as psychological risk, but still messy. The extreme example: A retiree with 100% equities would always be selling stock to live and therefore would be selling in downturns at lows by definition. Other slightly less aggressive investors would be able to hold out selling stocks for some months before they are forced to do so.


This raises 3 questions:

1. Would it be a good rule of thumb to maintain an AA by setting the percentage in equities to the lower of your psychological and real risk assessments?

2. Should one actively work on reducing or eliminating psychological intolerance to risk as defined above and simply address real risk?

3. Is the your-age-in-bonds recommendation a reasonable approach to handling all this in a more robust way (greater tolerance to volatility) without all the bother?
It might be a standard BH tenet, but remember that a lot of people are at various stages of life and investment experience. I can only draw on my own experiences, having invested through three significant bear markets.

Very few people can ascertain their real psychological risk until they've invested through a major bear market and even then, there's ultimately a realization that every bear market is different. Furthermore, your psychological risk is very, very different when you're 35 than when you're 55. There are plenty of people that patted themselves on the back for making it through the 2008-2009 downturn but are in completely different stages of their lives a decade later--and they may not be so sanguine the "next time."

I don't think you can eliminate psychological intolerance but you can acknowledge it and hopefully let it pass. I can't think of anyone who wasn't psychologically spooked in late 2008; the best anyone could have hoped for was white-knuckling it through the whole process. I'm going to guess that there were varying levels of "sins" during the 2008-2009 meltdown; some people may not have sold anything (a relatively small sin) but there were far fewer that were actively rebalancing during that period (no sin).

I'm not a fan of age-in-bonds although an investor just starting out might use it as a starting point. Later in life, those numbers are just too simplistic and have to be adapted individually.

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AtlasShrugged?
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Re: Psychological vs. Real Risk

Post by AtlasShrugged? » Sat Oct 13, 2018 7:08 am

I don't think you can eliminate psychological intolerance but you can acknowledge it and hopefully let it pass. I can't think of anyone who wasn't psychologically spooked in late 2008; the best anyone could have hoped for was white-knuckling it through the whole process. I'm going to guess that there were varying levels of "sins" during the 2008-2009 meltdown; some people may not have sold anything (a relatively small sin) but there were far fewer that were actively rebalancing during that period (no sin).
This....X1,000,000 = white knuckling through the whole process. That is so true.

I mitigate behavioral risk (what I think of as psychological risk) by having a written IPS. It is enormously helpful.

Artsdoc...I did not sell in 2008-09, I was a buyer all the way through. But that was by happenstance, not design. And I did not rebalance until much later.
“If you don't know, the thing to do is not to get scared, but to learn.”

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Re: Psychological vs. Real Risk

Post by 3funder » Sat Oct 13, 2018 7:35 am

KlangFool wrote:
Fri Oct 12, 2018 1:40 pm
livesoft wrote:
Fri Oct 12, 2018 1:36 pm
1. I don't think so. Almost every time someone loses big money, they worry a little bit or at least get a little bit uncomfortable. So if they set their AA to the lower of Psych or Real, then they will still feel the desire or wish not to lose money.

And there is another side to this. It is not just that they won't sell when they hit a lower band, but will they BUY to rebalance. I often read on the BH.org forum where someone says "I didn't sell", but they didn't buy either when they probably should have bought.
+1.

KlangFool
+2

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Re: Psychological vs. Real Risk

Post by Call_Me_Op » Sat Oct 13, 2018 7:53 am

Don't forget the psychological risk is real risk - to your health.
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Re: Psychological vs. Real Risk

Post by staythecourse » Sat Oct 13, 2018 8:06 am

Ron Scott wrote:
Fri Oct 12, 2018 10:07 am
The extreme example: A retiree with 100% equities would always be selling stock to live and therefore would be selling in downturns at lows by definition. Other slightly less aggressive investors would be able to hold out selling stocks for some months before they are forced to do so.
Interesting as your standpoint on this topic shows up in this example. The above couple while yes may be selling in a downmarket to free money up for monthly liabilities will also be gaining extra income when the market goes up when they are NOT selling. Since the market is up 2/3 of the years and a couple who may be doing this has MORE then enough "cushion" in the ratio of their portfolio size to monthly needs would make it an excellent plan still. Also, one is forgetting SS and any available pensions which are basically fixed income so they STILL wouldn't be 100% equities.

Good luck.
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Re: Psychological vs. Real Risk

Post by Artsdoctor » Sat Oct 13, 2018 9:09 am

AtlasShrugged? wrote:
Sat Oct 13, 2018 7:08 am
I don't think you can eliminate psychological intolerance but you can acknowledge it and hopefully let it pass. I can't think of anyone who wasn't psychologically spooked in late 2008; the best anyone could have hoped for was white-knuckling it through the whole process. I'm going to guess that there were varying levels of "sins" during the 2008-2009 meltdown; some people may not have sold anything (a relatively small sin) but there were far fewer that were actively rebalancing during that period (no sin).
This....X1,000,000 = white knuckling through the whole process. That is so true.

I mitigate behavioral risk (what I think of as psychological risk) by having a written IPS. It is enormously helpful.

Artsdoc...I did not sell in 2008-09, I was a buyer all the way through. But that was by happenstance, not design. And I did not rebalance until much later.
Yes. Then you're well-positioned and you did everything right. I also have an IPS which is helpful, but the most helpful to me was a financial diary which I kept throughout the entire 2008-2009 meltdown. I refer back to that diary occasionally whenever I start trying to rationalize tweaking my IPS. That brings me back to reality very quickly. I learned a lot about myself ten years ago; I'm now 10 years older and don't have it in me to go through that again with such a high equity exposure. I'm now invested much more conservatively because of this unexpectedly long bull market, probably too much so. But I don't need the psychological or real risk anymore.

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Re: Psychological vs. Real Risk

Post by Fallible » Sat Oct 13, 2018 10:01 am

Ron Scott wrote:
Fri Oct 12, 2018 10:07 am
Using asset allocation to manage volatility and downside risk is a standard BH tenet.

Psychological risk is what most financial writers spend their time on, i.e., the risk that someone's fear or nerves or whatever will cause them to sell equities unnecessarily at a low. Determining your psychological tolerance to risk requires some combination of experience and introspection, and of course becomes increasingly complex given an involved spouse with a different tolerance level. One oddity with the construct is it's ostensible constancy: One supposedly doesn't change one's tolerance level (with resultant changes in AA) much over time, as this story is told. There's a messiness to it but it is intuitive and most seem to come to terms with it.

Real risk (my ineloquent label as I forget what others call it) can be defined as the need to sell equities at a low for living expenses. Determining real risk is more mathematical in nature, combining information about your asset allocation, spending needs, breadth and duration of market downturns, to estimate what percentage of your portfolio would be sold low and how that will affect your financial position going forward. This involves running some scenarios with different assumptions about the market drop, duration, spending, etc. Not as messy as psychological risk, but still messy. The extreme example: A retiree with 100% equities would always be selling stock to live and therefore would be selling in downturns at lows by definition. Other slightly less aggressive investors would be able to hold out selling stocks for some months before they are forced to do so.


This raises 3 questions:

1. Would it be a good rule of thumb to maintain an AA by setting the percentage in equities to the lower of your psychological and real risk assessments?

2. Should one actively work on reducing or eliminating psychological intolerance to risk as defined above and simply address real risk?

3. Is the your-age-in-bonds recommendation a reasonable approach to handling all this in a more robust way (greater tolerance to volatility) without all the bother?
These are interesting thoughts and questions, but I'm not sure what is all that new. The Bogleheads philosophy, based on some of the best minds in investing and behavioral economics/finance, addresses such issues, which inevitably get back to knowing oneself, knowing one's need, ability, and willingness (risk tolerance) to take risk. After careful consideration of all that leads to an AA that, hopefully, is right for that particular investor, it's about emotional self-control, about discipline and an IPS to help maintain it.

There's a good reason so much is written about investor psychology and resulting behavior: the stock market is very much based on the emotions of fear and greed.
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Ron Scott
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Re: Psychological vs. Real Risk

Post by Ron Scott » Sat Oct 13, 2018 10:55 am

Fallible wrote:
Sat Oct 13, 2018 10:01 am
Ron Scott wrote:
Fri Oct 12, 2018 10:07 am
Using asset allocation to manage volatility and downside risk is a standard BH tenet.

Psychological risk is what most financial writers spend their time on, i.e., the risk that someone's fear or nerves or whatever will cause them to sell equities unnecessarily at a low. Determining your psychological tolerance to risk requires some combination of experience and introspection, and of course becomes increasingly complex given an involved spouse with a different tolerance level. One oddity with the construct is it's ostensible constancy: One supposedly doesn't change one's tolerance level (with resultant changes in AA) much over time, as this story is told. There's a messiness to it but it is intuitive and most seem to come to terms with it.

Real risk (my ineloquent label as I forget what others call it) can be defined as the need to sell equities at a low for living expenses. Determining real risk is more mathematical in nature, combining information about your asset allocation, spending needs, breadth and duration of market downturns, to estimate what percentage of your portfolio would be sold low and how that will affect your financial position going forward. This involves running some scenarios with different assumptions about the market drop, duration, spending, etc. Not as messy as psychological risk, but still messy. The extreme example: A retiree with 100% equities would always be selling stock to live and therefore would be selling in downturns at lows by definition. Other slightly less aggressive investors would be able to hold out selling stocks for some months before they are forced to do so.


This raises 3 questions:

1. Would it be a good rule of thumb to maintain an AA by setting the percentage in equities to the lower of your psychological and real risk assessments?

2. Should one actively work on reducing or eliminating psychological intolerance to risk as defined above and simply address real risk?

3. Is the your-age-in-bonds recommendation a reasonable approach to handling all this in a more robust way (greater tolerance to volatility) without all the bother?
These are interesting thoughts and questions, but I'm not sure what is all that new. The Bogleheads philosophy, based on some of the best minds in investing and behavioral economics/finance, addresses such issues, which inevitably get back to knowing oneself, knowing one's need, ability, and willingness (risk tolerance) to take risk. After careful consideration of all that leads to an AA that, hopefully, is right for that particular investor, it's about emotional self-control, about discipline and an IPS to help maintain it.

There's a good reason so much is written about investor psychology and resulting behavior: the stock market is very much based on the emotions of fear and greed.
I threw it out there because there really are widely divergent opinions on this board of BHs about some very fundamental AA issues.

Some say your-age-in-bonds. Some say your-age-minus-10-in bonds. Some like the brokerages' psychological risk-tolerance tests. Some just go with 40-60, 50-50 or 60-40 because its traditional to do so. Some model their future 30 years by the past 80 years of historical data. Some work to ensure they can live off their bonds for 5-10 years (15-20 years if you like Bernstein's approach). Bogle himself seems to stick with 50-50 out of habit. And as above some feel 100% equities, even in retirement, is perfectly fine.

Consensus eludes us--unlike more hard tenets like investing in funds with low fees, TSM, etc.
Retirement is a game best played by those prepared for more volatility in the future than has been seen in the past. The solution is not to predict investment losses but to prepare for them.

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Re: Psychological vs. Real Risk

Post by Artsdoctor » Sat Oct 13, 2018 12:30 pm

Ron,

You're right in questioning what sort of consensus, if any, one can reach on this forum. I don't think there are any rules because there are just fundamental differences in approach.

There is probably one thing, above all, that perhaps we can agree on. Whatever one decides to do, there should be thoughtful explanation as to why it's being done. Conversely, the one thing that investors should STRIVE to never do is to invest in something that he/she does not understand or cannot explain.

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Re: Psychological vs. Real Risk

Post by Ron Scott » Sat Oct 13, 2018 12:43 pm

Artsdoctor wrote:
Sat Oct 13, 2018 12:30 pm
Ron,

You're right in questioning what sort of consensus, if any, one can reach on this forum. I don't think there are any rules because there are just fundamental differences in approach.

There is probably one thing, above all, that perhaps we can agree on. Whatever one decides to do, there should be thoughtful explanation as to why it's being done. Conversely, the one thing that investors should STRIVE to never do is to invest in something that he/she does not understand or cannot explain.
Wise!
Retirement is a game best played by those prepared for more volatility in the future than has been seen in the past. The solution is not to predict investment losses but to prepare for them.

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Re: Psychological vs. Real Risk

Post by Fallible » Sat Oct 13, 2018 2:15 pm

Ron Scott wrote:
Sat Oct 13, 2018 12:43 pm
Artsdoctor wrote:
Sat Oct 13, 2018 12:30 pm
Ron,

You're right in questioning what sort of consensus, if any, one can reach on this forum. I don't think there are any rules because there are just fundamental differences in approach.

There is probably one thing, above all, that perhaps we can agree on. Whatever one decides to do, there should be thoughtful explanation as to why it's being done. Conversely, the one thing that investors should STRIVE to never do is to invest in something that he/she does not understand or cannot explain.
Wise!
I think, too, that it’s important to take into account where some of these differing approaches come from on the forum, including suspected trolls who only want to bash passive investing, and those who misunderstand basic investing terms such as market timing, diversity, simplicity, risk, and even stay the course. (A recent thread nicely discussed this problem of misunderstood investing terms).

So yes to Artsdoctor that to succeed, all investors should invest only in what they truly understand. And that includes understanding themselves - nothing more fundamental than that.
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Re: Psychological vs. Real Risk

Post by VictoriaF » Sat Oct 13, 2018 3:02 pm

The real risk is not that your portfolio would under-perform in comparison so some index or some asset allocation on the efficient frontier. The real risk is that you would not have enough money in retirement.

That's why the most prudent approach is that recommended by Bill Bernstein:
- Liability Matching Portfolio (LMP) for your needs
- Risk Portfolio (RP) for your heirs and extravagances.

When you look at your income and assets from the LMP/RP perspective the asset allocation becomes irrelevant. If you have large Social Security and pensions and low needs, all your liquid assets could be RP and you could invest them into literally anything.

If, on the other hand, your needs far exceed your income from Social Security and pensions, you should invest most of your assets into the safest assets and income such as I Bonds, TIPS, or SPIAs.

Victoria
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Re: Psychological vs. Real Risk

Post by Artsdoctor » Sat Oct 13, 2018 5:09 pm

VictoriaF wrote:
Sat Oct 13, 2018 3:02 pm
The real risk is not that your portfolio would under-perform in comparison so some index or some asset allocation on the efficient frontier. The real risk is that you would not have enough money in retirement.

That's why the most prudent approach is that recommended by Bill Bernstein:
- Liability Matching Portfolio (LMP) for your needs
- Risk Portfolio (RP) for your heirs and extravagances.

When you look at your income and assets from the LMP/RP perspective the asset allocation becomes irrelevant. If you have large Social Security and pensions and low needs, all your liquid assets could be RP and you could invest them into literally anything.

If, on the other hand, your needs far exceed your income from Social Security and pensions, you should invest most of your assets into the safest assets and income such as I Bonds, TIPS, or SPIAs.

Victoria
Now, now, Victoria. You know as well as I do that not everyone would agree with your (and my) approach. There are two main groups in investment philosophies: the probability-based group and the safety-first group. I am a very big proponent of the LMP/RP idea, as you are (that would be the "safety-first" group). However, the majority of investors, including the Vanguard philosophy itself, is centered around probability-based investing.

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Re: Psychological vs. Real Risk

Post by staythecourse » Sat Oct 13, 2018 5:41 pm

VictoriaF wrote:
Sat Oct 13, 2018 3:02 pm
The real risk is not that your portfolio would under-perform in comparison so some index or some asset allocation on the efficient frontier. The real risk is that you would not have enough money in retirement.

That's why the most prudent approach is that recommended by Bill Bernstein:
- Liability Matching Portfolio (LMP) for your needs
- Risk Portfolio (RP) for your heirs and extravagances.

When you look at your income and assets from the LMP/RP perspective the asset allocation becomes irrelevant. If you have large Social Security and pensions and low needs, all your liquid assets could be RP and you could invest them into literally anything.

If, on the other hand, your needs far exceed your income from Social Security and pensions, you should invest most of your assets into the safest assets and income such as I Bonds, TIPS, or SPIAs.

Victoria
Agreed. It is so obvious I advocated the same approach before I heard Dr. Bernstein and ?Mr. Brodie (BU professor) advocate the same. Just seems obvious. Asset allocation in this group of investors (retirees) should be AFTER the fact. Figure out how much in LMP you need then the rest in equities and that is how you figure out asset allocation and not, "Hey I think 30/70 sounds good".

Good luck.
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Re: Psychological vs. Real Risk

Post by 2015 » Sat Oct 13, 2018 9:37 pm

Artsdoctor wrote:
Sat Oct 13, 2018 5:09 pm
VictoriaF wrote:
Sat Oct 13, 2018 3:02 pm
The real risk is not that your portfolio would under-perform in comparison so some index or some asset allocation on the efficient frontier. The real risk is that you would not have enough money in retirement.

That's why the most prudent approach is that recommended by Bill Bernstein:
- Liability Matching Portfolio (LMP) for your needs
- Risk Portfolio (RP) for your heirs and extravagances.

When you look at your income and assets from the LMP/RP perspective the asset allocation becomes irrelevant. If you have large Social Security and pensions and low needs, all your liquid assets could be RP and you could invest them into literally anything.

If, on the other hand, your needs far exceed your income from Social Security and pensions, you should invest most of your assets into the safest assets and income such as I Bonds, TIPS, or SPIAs.

Victoria
Now, now, Victoria. You know as well as I do that not everyone would agree with your (and my) approach. There are two main groups in investment philosophies: the probability-based group and the safety-first group. I am a very big proponent of the LMP/RP idea, as you are (that would be the "safety-first" group). However, the majority of investors, including the Vanguard philosophy itself, is centered around probability-based investing.
This is why it's so important to know yourself. It's no good playing a game others are playing where you don't belong. Based on my lifelong relationship with risk, I know that probability based investing would sooner or later put me over a behavioral cliff of some sort or another. Thus, I'm in the safety-first camp and can swat away ideas related to probability based investing.

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Re: Psychological vs. Real Risk

Post by DorothyB » Sat Oct 13, 2018 9:52 pm

chevca wrote:
Fri Oct 12, 2018 1:47 pm
If one "needs" to sell equities for living expenses, they better have lots of $$ in equities or not have money needed for living expenses in equities. Shoot, even bond funds can go down. . . . Living expense money should probably be kept in the bank, so it's nice and safe. Keep some in stock, some in bonds, and pull a year or three years or whatever of living expense money out of whichever is doing better at the time. Keep it simple.
That is sort of what I am doing. I have what I think I would need to pull out for 4 years (after dividends, social security & pension) in money market and other investments that should be safe if stocks & bonds both go way down. The rest is invested mostly in stocks, some in bonds.

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