Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

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Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by Lauretta » Sun Oct 01, 2017 11:29 am

I am quite new to investing and I have been influenced by a number of people, like Buffett in this article, who think that over the long term stocks are actually the least risky asset.
http://fortune.com/2012/02/09/warren-bu ... and-bonds/
In contrast, I am reading posts on Bogleheads where the advice is that one should not own more stocks than one's willingness, ability and need to take risk requires. This implies a different conception of risk I believe, and also that once you've 'won the game', since your need for growth is no longer there, it's best to have a small AA in stocks and a high AA in bonds. At least I have seen this advice in several posts, if I understood correctly.
How can this be reconciled with Buffett's advice? Buffett basically considers bonds a return-free risky asset; and thinks that stocks over a longish time horizon are basically the safest bet. Is it due to a different conception of risk? (risk understood as volatility in this Forum, and as 'the probability -- the reasoned probability -- of the investment causing its owner a loss of purchasing power over his contemplated holding period' for Buffett).
Thanks
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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by dbr » Sun Oct 01, 2017 11:59 am

I would say Mr. Buffett has a different idea regarding what investing is all about, specifically that it is a business enterprise and not how an individual goes about saving excess income for later consumption, aka retirement. As such his ideas of risk are not contradictory to n/a/w so much as orthogonal to it.

That said I think one can rationalize n/a/w to his ideas of what is risky. Need translates into what return is needed to meet objectives. Bonds in Buffetts world do not produce adequate return, so one needs investments that do, aka stocks. Investments that are not expected to meet objectives are risky. N/a/w agrees with that. Probably the point of departure for Buffett is about ability and willingness. Buffett has an abiding faith in the soundness and prospects for the American economy which says that investing in stocks of well chosen American companies will generate long term rewards. As long as one keeps one's financial situation on a sound basis including preservation of funds for liquidity, not making stupid deals, and not overspending one's resources, one has the ability to take risk in stocks. Finally, and crucially, one has to invest for the long run and be prepared for volatility. In other words willingness means development of the ability to take the long view, not panic, and stick to a plan.

Maybe that helps.

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by alex_686 » Sun Oct 01, 2017 12:02 pm

Lots of small points.

Let us start off with bonds. Currently bonds are a "return free asset". I don't quite buy into that theory 100% but it has some strong points to it. Historically bonds have had positive returns. We live in a odd time. I will point out that Buffett does argue that one should have a large slug of cash for flexibility. Cash can be considered a special class of bonds and cash has historically had negative inflation adjusted returns.

Volatility is not risk. It is one measure of risk. Volatility is a very powerful tool but one should have a couple of tools in your tool box and keep one's eye out on the larger picture. For example, Buffett focuses on preservation of inflation adjusted principle. BRK has a long time horizon - say 30 years - and the ability to take risk.

I think risk is about the failure to meet your goals. Who can say they won't withdraw investment funds over the next 30 years. Think about house, cars, weddings, disability, illness, unexpected opportunities. We often accept negative real returns because we can't bear the risk - for example life insurance and annuities.

The risk/return profile for Berkshire Hathaway is different than a individual's risk/return profile.

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by Lauretta » Sun Oct 01, 2017 12:30 pm

dbr wrote:
Sun Oct 01, 2017 11:59 am
I would say Mr. Buffett has a different idea regarding what investing is all about, specifically that it is a business enterprise and not how an individual goes about saving excess income for later consumption, aka retirement. As such his ideas of risk are not contradictory to n/a/w so much as orthogonal to it.

That said I think one can rationalize n/a/w to his ideas of what is risky. Need translates into what return is needed to meet objectives. Bonds in Buffetts world do not produce adequate return, so one needs investments that do, aka stocks. Investments that are not expected to meet objectives are risky. N/a/w agrees with that. Probably the point of departure for Buffett is about ability and willingness. Buffett has an abiding faith in the soundness and prospects for the American economy which says that investing in stocks of well chosen American companies will generate long term rewards. As long as one keeps one's financial situation on a sound basis including preservation of funds for liquidity, not making stupid deals, and not overspending one's resources, one has the ability to take risk in stocks. Finally, and crucially, one has to invest for the long run and be prepared for volatility. In other words willingness means development of the ability to take the long view, not panic, and stick to a plan.

Maybe that helps.
Thanks for the explanations. :happy I guess the tricky bit for me is to clearly understand the 'need' part. If I calculate my total assets including the rental properties I have (together with the ETFs I recently bought aftr selling some real estate, and the cash), then my annual expenses are maybe 1,5-2% of that. Actually this is mainly because in Europe we tend to live on much less than in the US! I am 48 so I guess that I can perhaps retire (I'm just not confident enough to take the step!) so that I can do things that I really care about now, not worrying about income. But concerning my investments, should I be focused on minimising the risk that e.g. my savings will lose purchasing power over time, or should I worry more about DD risk? The objective is of course to be able to support myself in retirement through rental income (about 1/3 of my worth) and the liquid assets I have.
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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by Lauretta » Sun Oct 01, 2017 12:35 pm

alex_686 wrote:
Sun Oct 01, 2017 12:02 pm
Lots of small points.

Let us start off with bonds. Currently bonds are a "return free asset". I don't quite buy into that theory 100% but it has some strong points to it. Historically bonds have had positive returns. We live in a odd time. I will point out that Buffett does argue that one should have a large slug of cash for flexibility. Cash can be considered a special class of bonds and cash has historically had negative inflation adjusted returns.

Volatility is not risk. It is one measure of risk. Volatility is a very powerful tool but one should have a couple of tools in your tool box and keep one's eye out on the larger picture. For example, Buffett focuses on preservation of inflation adjusted principle. BRK has a long time horizon - say 30 years - and the ability to take risk.

I think risk is about the failure to meet your goals. Who can say they won't withdraw investment funds over the next 30 years. Think about house, cars, weddings, disability, illness, unexpected opportunities. We often accept negative real returns because we can't bear the risk - for example life insurance and annuities.

The risk/return profile for Berkshire Hathaway is different than a individual's risk/return profile.
Thanks for clarifying these points. :happy So one takeway from this I guess is that if you have say 20-30 yrs worth of expenses in cash (but then who knows about e.g. inflation, and about how one's expenses will precisely evolve?) putting the rest in stocks probably makes most sense.
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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by stemikger » Sun Oct 01, 2017 12:46 pm

First off who are any of us to disagree with the Oracle. However, we are mere mortals and he is not. lol. Well maybe, but definitely a different form.

I don't really disagree with Warren, and I'm sure in the long run stocks will outperform. Having said that, let's say you have $500K in your 401K at 55 all in equities and the market drops 50%. Can you bear to see that $500K turn into $250K? Even though it may be a temporary drop, would you be able to handle it? At that age, I don't think I could and who knows how long it will take to come back. As a mere mortal, your stomach will churn with each passing day and if it is longer than has been in the past, you will really start regretting your decision and possibly do the worst possible thing and lock in your losses. So with all that said, as we get older hold the proper asset allocation so you have a smoother and easier investing life. I am 53 and hold my goldilocks portfolio of 60/40 (stocks/bonds). All U.S.

I would say younger investors with 40 years ahead of them should be heavy in equities.
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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by nisiprius » Sun Oct 01, 2017 12:53 pm

Lauretta, the thing I would point out is that the proposition that stocks are not risky, or less risky, or become less risky in the long run is controversial. Some say so, some do not. So do not be too quick to take it as simple fact. This point is frequently debated in this forum. I don't want to insist strongly on "what point of view is right" but I do want you to at least read the summary of an academic paper. The meaning and implications of this paper have been debated in this forum, as well as the meaning of "risk," and what Buffett is actually saying, and so forth and so on.

Pastor, Lubos and Stambaugh, Robert F. (2011), Are Stocks Really Less Volatile in the Long Run?
According to conventional wisdom, annualized volatility of stock returns is lower over long horizons than over short horizons, due to mean reversion induced by return predictability. In contrast, we find that stocks are substantially more volatile over long horizons from an investor's perspective. This perspective recognizes that parameters are uncertain, even with two centuries of data, and that observable predictors imperfectly deliver the conditional expected return. Mean reversion contributes strongly to reducing long-horizon variance, but it is more than offset by various uncertainties faced by the investor, especially uncertainty about the expected return. The same uncertainties reduce desired stock allocations of long-horizon investors contemplating target-date funds.
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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by dbr » Sun Oct 01, 2017 12:55 pm

Lauretta wrote:
Sun Oct 01, 2017 12:30 pm
dbr wrote:
Sun Oct 01, 2017 11:59 am
I would say Mr. Buffett has a different idea regarding what investing is all about, specifically that it is a business enterprise and not how an individual goes about saving excess income for later consumption, aka retirement. As such his ideas of risk are not contradictory to n/a/w so much as orthogonal to it.

That said I think one can rationalize n/a/w to his ideas of what is risky. Need translates into what return is needed to meet objectives. Bonds in Buffetts world do not produce adequate return, so one needs investments that do, aka stocks. Investments that are not expected to meet objectives are risky. N/a/w agrees with that. Probably the point of departure for Buffett is about ability and willingness. Buffett has an abiding faith in the soundness and prospects for the American economy which says that investing in stocks of well chosen American companies will generate long term rewards. As long as one keeps one's financial situation on a sound basis including preservation of funds for liquidity, not making stupid deals, and not overspending one's resources, one has the ability to take risk in stocks. Finally, and crucially, one has to invest for the long run and be prepared for volatility. In other words willingness means development of the ability to take the long view, not panic, and stick to a plan.

Maybe that helps.
Thanks for the explanations. :happy I guess the tricky bit for me is to clearly understand the 'need' part. If I calculate my total assets including the rental properties I have (together with the ETFs I recently bought aftr selling some real estate, and the cash), then my annual expenses are maybe 1,5-2% of that. Actually this is mainly because in Europe we tend to live on much less than in the US! I am 48 so I guess that I can perhaps retire (I'm just not confident enough to take the step!) so that I can do things that I really care about now, not worrying about income. But concerning my investments, should I be focused on minimising the risk that e.g. my savings will lose purchasing power over time, or should I worry more about DD risk? The objective is of course to be able to support myself in retirement through rental income (about 1/3 of my worth) and the liquid assets I have.
To project whether or not your assets will meet your needs over the rest of your lifetime you have to model your expenses and your income sources taking into account inflation, income streams, investment returns, changes in situation such as selling something, buying something, adding or removing expenses and so on. You have to do this allowing for the statistical uncertainty in inflation, investment returns, and so on. Models such as FireCalc and many others look at the problem this way. It is a holistic calculation that does try to focus on any single risk in isolation or any single asset in isolation.

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by garlandwhizzer » Sun Oct 01, 2017 1:02 pm

A 100% stock portfolio, or a 90/10 as Buffett selected for his wife, have higher expected long term returns than portfolios with more bonds. Warren can stick with that heavy tilt to equity through thick and thin because he's a multi-billionaire with a very strong stock market stomach, and he keeps his focus solely on long term returns rather than current volatility. Most of us cannot emotionally tolerate massive losses to our hard earned investment portfolios in a severe market downturn, or even marked volatility. Selling equity at or near the bottom of a market decline is very common with investors. To protect ourselves from behavioral errors and to smooth out the ups and downs of the markets we often select a higher bond allocation. This is particularly true as we age. When you're 70, you can't wait forever for the long term payoff and need to have safe non-volatile assets to provide security. Warren has the ability to take as much risk as he desires and the willingness to do so. He has no need to do so, but his overriding goal is to produce maximal long term return. If you're in similar circumstances, it's entirely rational. What others have to do is to know themselves and their financial circumstances well enough to fit their portfolio to their specifics.

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by RadAudit » Sun Oct 01, 2017 1:04 pm

Lauretta wrote:
Sun Oct 01, 2017 12:30 pm
I guess the tricky bit for me is to clearly understand the 'need' part.
I'm having trouble with that, too. I look at it as the need to take risk to meet your goals.

Two comments that sort of helped me get a handle on the idea are
(1) Buffett once said about a company “To make money they didn’t have & didn’t need, they risked what they did have & did need.” and
(2) A financial advisor (Bernstein[?]) tells the story of a couple who came to him for advice with a portfolio of $3 mil. They had lost $10 mil of their portfolio by continuing to make high risk investments after they had accumulated enough money to live comfortably. The idea here was once you've won the game, stop playing.

I'm definitely not anywhere near the level of money referred to in those comments. But, I believe it means that if you have reached your goal you can dial back the degree of risk in your portfolio. A closely associated idea is willingness to take risk to meet your goals. As I got older, my tolerance for large drops in the portfolio decreased dramatically. (1987, 2000 and 2008). So, I started to dial back the risk in the portfolio as I aged. Of course, the fun part was trying to meet the goals with a portfolio which had a lower expected return. But that's another story.
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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by Lauretta » Sun Oct 01, 2017 1:08 pm

nisiprius wrote:
Sun Oct 01, 2017 12:53 pm
Lauretta, the thing I would point out is that the proposition that stocks are not risky, or less risky, or become less risky in the long run is controversial. Some say so, some do not. So do not be too quick to take it as simple fact. This point is frequently debated in this forum. I don't want to insist strongly on "what point of view is right" but I do want you to at least read the summary of an academic paper. The meaning and implications of this paper have been debated in this forum, as well as the meaning of "risk," and what Buffett is actually saying, and so forth and so on.

Pastor, Lubos and Stambaugh, Robert F. (2011), Are Stocks Really Less Volatile in the Long Run?
According to conventional wisdom, annualized volatility of stock returns is lower over long horizons than over short horizons, due to mean reversion induced by return predictability. In contrast, we find that stocks are substantially more volatile over long horizons from an investor's perspective. This perspective recognizes that parameters are uncertain, even with two centuries of data, and that observable predictors imperfectly deliver the conditional expected return. Mean reversion contributes strongly to reducing long-horizon variance, but it is more than offset by various uncertainties faced by the investor, especially uncertainty about the expected return. The same uncertainties reduce desired stock allocations of long-horizon investors contemplating target-date funds.
Thanks, I will need to read the whole paper, it does suggest that things are not straightforward; I had been influenced by videos such as these
https://www.youtube.com/watch?v=WRrFIyhKr9w
or by the article I quoted; though reality seems more complicated. Probably TIPs (or the equivalent in Europe for me) are a good idea then to make sure part of one's capital is preserved.
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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by dbr » Sun Oct 01, 2017 1:15 pm

Lauretta wrote:
Sun Oct 01, 2017 1:08 pm
nisiprius wrote:
Sun Oct 01, 2017 12:53 pm
Lauretta, the thing I would point out is that the proposition that stocks are not risky, or less risky, or become less risky in the long run is controversial. Some say so, some do not. So do not be too quick to take it as simple fact. This point is frequently debated in this forum. I don't want to insist strongly on "what point of view is right" but I do want you to at least read the summary of an academic paper. The meaning and implications of this paper have been debated in this forum, as well as the meaning of "risk," and what Buffett is actually saying, and so forth and so on.

Pastor, Lubos and Stambaugh, Robert F. (2011), Are Stocks Really Less Volatile in the Long Run?
According to conventional wisdom, annualized volatility of stock returns is lower over long horizons than over short horizons, due to mean reversion induced by return predictability. In contrast, we find that stocks are substantially more volatile over long horizons from an investor's perspective. This perspective recognizes that parameters are uncertain, even with two centuries of data, and that observable predictors imperfectly deliver the conditional expected return. Mean reversion contributes strongly to reducing long-horizon variance, but it is more than offset by various uncertainties faced by the investor, especially uncertainty about the expected return. The same uncertainties reduce desired stock allocations of long-horizon investors contemplating target-date funds.
Thanks, I will need to read the whole paper, it does suggest that things are not straightforward; I had been influenced by videos such as these
https://www.youtube.com/watch?v=WRrFIyhKr9w
or by the article I quoted; though reality seems more complicated. Probably TIPs (or the equivalent in Europe for me) are a good idea then to make sure part of one's capital is preserved.
If preservation of capital is an objective, then that is your need. This is different from, for example, providing an income stream in retirement, or growing wealth over time. If that is the entire and only objective then it would in theory be met by holding all the assets in TIPS or equivalent. In that case income for you or growth of assets would be limited to the real return of the bonds, maybe about 1% today, but that income could be variable. Also, one should understand possible losses to taxes.

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by Lauretta » Sun Oct 01, 2017 1:17 pm

RadAudit wrote:
Sun Oct 01, 2017 1:04 pm
But, I believe it means that if you have reached your goal you can dial back the degree of risk in your portfolio.
But then if you had enough money like the couple in Bernstein's story, what would you do to stop taking risks? Go to cash? Then you'd have inflation risk... :( Perhaps buy TIPs?
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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by Lauretta » Sun Oct 01, 2017 1:28 pm

dbr wrote:
Sun Oct 01, 2017 1:15 pm
If that is the entire and only objective then it would in theory be met by holding all the assets in TIPS or equivalent. In that case income for you or growth of assets would be limited to the real return of the bonds, maybe about 1% today, but that income could be variable. Also, one should understand possible losses to taxes.
Thanks again. I am beginning to see more concretely what its means to plan one's investments by focussing on one's objectives.
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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by alex_686 » Sun Oct 01, 2017 1:41 pm

Lauretta wrote:
Sun Oct 01, 2017 12:35 pm
Thanks for clarifying these points. :happy So one takeway from this I guess is that if you have say 20-30 yrs worth of expenses in cash (but then who knows about e.g. inflation, and about how one's expenses will precisely evolve?) putting the rest in stocks probably makes most sense.
Not exactly. I will give you 2 examples that might make sense if you are a landlord.

First, imagine it is 2008 in the US where property prices are going bust. You know a couple that needs to sell their house because they are divorcing or moving to another state. You walk over to their house with a briefcase full of cash and make a low ball offer that is 40% below their asking price. This is what Mr. Buffet does all the time. Cash in king during times of crisis. Mr. Buffet keeps a pile of cash to give him flexibility. That being said, as a active trade and a market timer he needs that flexibility.

Second, imagine that the property will have negative cash flows for the next 10 to 20 years. A young oak grove. Raw land that needs to be developed first. An apartment with a viager. Knowing you can't sell it for 20 years would you do this project? Remember, you don't know when you will need cash for a new car or disability. BRK might. They have the time horizon.

It kind of comes down to liquidity risk. I personally think that Buffet is a little flippant and arrogant. He is safely behind thick castle walls and can sit out the 10 years the barbarians hordes raze the countryside. You annual expenses are 2% of your portfolio, Buffet and Berkshire is way lower than that.

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by lazyday » Sun Oct 01, 2017 1:43 pm

Lauretta wrote:
Sun Oct 01, 2017 1:17 pm
RadAudit wrote:
Sun Oct 01, 2017 1:04 pm
But, I believe it means that if you have reached your goal you can dial back the degree of risk in your portfolio.
But then if you had enough money like the couple in Bernstein's story, what would you do to stop taking risks? Go to cash? Then you'd have inflation risk... :( Perhaps buy TIPs?
If for example, you're happy spending 1% of your portfolio per year, you invest passively like a Boglehead, and global CAEP (earnings yield) is around 5% like it is today, then you don't have to stop taking risk. Almost any diversified Boglehead asset allocation would be fine.

W Bernstein's Deep Risk is a good read, that might be where he suggests that you're ok if you're spending less than half the dividend yield of the broad market. (really I think he suggests using half the dividend yield as part of a liability matching portfolio)

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by alex_686 » Sun Oct 01, 2017 1:47 pm

Lauretta wrote:
Sun Oct 01, 2017 1:17 pm
RadAudit wrote:
Sun Oct 01, 2017 1:04 pm
But, I believe it means that if you have reached your goal you can dial back the degree of risk in your portfolio.
But then if you had enough money like the couple in Bernstein's story, what would you do to stop taking risks? Go to cash? Then you'd have inflation risk... :( Perhaps buy TIPs?
There is a contradiction here. As your wealth increases your ability to take risks increases but one's willingness to take risks can fall. Here is a question for you. Do you want to maximize your risk-adjusted returns? Go towards stocks. Do you want to minimize the chance that you will fail to meet your goals? Go towards bonds. TIPS is the ultimate bond - one is basically guaranteed principle protection, no risk, and no return. FYI, there is no technically correct answer - it is personal preference.

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by Lauretta » Sun Oct 01, 2017 1:59 pm

alex_686 wrote:
Sun Oct 01, 2017 1:41 pm


First, imagine it is 2008 in the US where property prices are going bust. You know a couple that needs to sell their house because they are divorcing or moving to another state. You walk over to their house with a briefcase full of cash and make a low ball offer that is 40% below their asking price. This is what Mr. Buffet does all the time. Cash in king during times of crisis. Mr. Buffet keeps a pile of cash to give him flexibility. That being said, as a active trade and a market timer he needs that flexibility.

Second, imagine that the property will have negative cash flows for the next 10 to 20 years. A young oak grove. Raw land that needs to be developed first. An apartment with a viager. Knowing you can't sell it for 20 years would you do this project? Remember, you don't know when you will need cash for a new car or disability. BRK might. They have the time horizon.

It kind of comes down to liquidity risk. I personally think that Buffet is a little flippant and arrogant. He is safely behind thick castle walls and can sit out the 10 years the barbarians hordes raze the countryside. You annual expenses are 2% of your portfolio, Buffet and Berkshire is way lower than that.
Thank you for these explanations: the comparisons with real estate make it really clear to me!
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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by Lauretta » Sun Oct 01, 2017 2:21 pm

alex_686 wrote:
Sun Oct 01, 2017 1:47 pm
Lauretta wrote:
Sun Oct 01, 2017 1:17 pm
RadAudit wrote:
Sun Oct 01, 2017 1:04 pm
But, I believe it means that if you have reached your goal you can dial back the degree of risk in your portfolio.
But then if you had enough money like the couple in Bernstein's story, what would you do to stop taking risks? Go to cash? Then you'd have inflation risk... :( Perhaps buy TIPs?
There is a contradiction here. As your wealth increases your ability to take risks increases but one's willingness to take risks can fall. Here is a question for you. Do you want to maximize your risk-adjusted returns? Go towards stocks. Do you want to minimize the chance that you will fail to meet your goals? Go towards bonds. TIPS is the ultimate bond - one is basically guaranteed principle protection, no risk, and no return. FYI, there is no technically correct answer - it is personal preference.
Also, some people wrote on this Forum that your need falls as your wealth increases, and its the lowest of the 3 that will determine your decision. In answer to your question, rationally I want to minimize the chance of failing to meet my goals of course. But I have also invested in stocks because of my understanding that in the long run they were actually safer as I said in the OP. Also emotionally I realise that I'm enjoying investing in stocks (and learning about factors etc), but I think that this is mainly due to the fact that since I began investing they've gone up, sometimes pretty fast. When they start going down it will be a different matter... I guess for a European investor like me German bonds protected against inflation should represent the ultimate safety then.
Last edited by Lauretta on Sun Oct 01, 2017 2:24 pm, edited 1 time in total.
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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by dbr » Sun Oct 01, 2017 2:23 pm

Lauretta wrote:
Sun Oct 01, 2017 2:21 pm
alex_686 wrote:
Sun Oct 01, 2017 1:47 pm
Lauretta wrote:
Sun Oct 01, 2017 1:17 pm
RadAudit wrote:
Sun Oct 01, 2017 1:04 pm
But, I believe it means that if you have reached your goal you can dial back the degree of risk in your portfolio.
But then if you had enough money like the couple in Bernstein's story, what would you do to stop taking risks? Go to cash? Then you'd have inflation risk... :( Perhaps buy TIPs?
There is a contradiction here. As your wealth increases your ability to take risks increases but one's willingness to take risks can fall. Here is a question for you. Do you want to maximize your risk-adjusted returns? Go towards stocks. Do you want to minimize the chance that you will fail to meet your goals? Go towards bonds. TIPS is the ultimate bond - one is basically guaranteed principle protection, no risk, and no return. FYI, there is no technically correct answer - it is personal preference.
Also, some people wrote on this Forum that your need falls as your wealth increases, and its the lowest of the 3 that will determine your decision. In answer to your question, rationally I want to minimize the chance of failing to meet my goals of course. But I have also invested in stocks because of my understanding that in the long run they were actually safer as I said in the OP. Also emotionally I realise that I'm enjoying investing in stocks (and learning about factors etc), but I think that this is mainly due to the fact that since I began investing they've gone up, sometimes pretty fact. When they start going down it will be a different matter... I guess for a European investor like me German bonds protected against inflation should represent the ultimate safety then.
"Safe" and "Safety" are undefined terms. I would advise carefully examining what these things mean to you in concrete terms.

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by Dude2 » Sun Oct 01, 2017 2:24 pm

Have you seen this HBO documentary on Warren Buffett?

Before you lend credence to his words, you might want to see who it is that is giving this advice. It was a game-changer for me.

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by Lauretta » Sun Oct 01, 2017 2:38 pm

Dude2 wrote:
Sun Oct 01, 2017 2:24 pm
Have you seen this HBO documentary on Warren Buffett?

Before you lend credence to his words, you might want to see who it is that is giving this advice. It was a game-changer for me.
Yes I think I saw it, though I had not yet begun learning about the stock market then. I remember liking particularly his ex-wife, and realising - when I saw the story of her illness - how even one of the richest men in the world is completely impotent in the face of the illness and death of a loved one (I had a similar feeling when I saw pictures of Steve Jobs ill with cancer). Anyway, this is not really relevant to the thread - can you share in what sense watching the documentary was a game-changer for you?
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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by Dude2 » Sun Oct 01, 2017 2:44 pm

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by Kevin M » Sun Oct 01, 2017 2:47 pm

I think Buffet conflates the low expected return of safe fixed income with risk. Safe fixed income is not risky in the long run, it is low return in the long run.

Investment risk is the uncertainty that you'll earn the expected return of the investment. Buffet, and many on this forum, seem to have 100% confidence, or close to it, that stocks will earn a real return higher than safe fixed income as long as your time horizon is long enough. That may be 10 years, or it may be 30 years. Buffet speaks in terms of a multi-decade time horizon, so I assume that for him at least 20 years is required to qualify as long term.

From this perspective, stocks may have a larger dispersion of returns over a long time horizon, but even the worst outcome is assumed to be better than the more certain outcome of fixed income. Some of us believe that this confidence is not warranted, and the paper referenced by Nisiprius is a good academic explanation of why.

We can use TIPS as a reference, since these have essentially no credit risk, no inflation risk, so if held to maturity, you will earn about the real yield (with some uncertainty due to reinvestment risk). Currently you earn a positive real yield on even a 5-year TIPS, at 0.24%, and the 30-year TIPS yield is 0.94%. Daily Treasury Real Yield Curve Rates. So currently, it is not true that fixed income offers no return, as long as your investment horizon is at least five years.

So to the extent that you are certain that stocks will earn more than 1% real over a 30-year time horizon, you should invest in stocks for that time horizon. If you are not so certain, and you don't have the need for a real return of more than 1% for a 30-year time horizon, the 30-year TIPS is a more appropriate investment. If you have the need for more than a 1% return, and you have the ability and willingness to take the risk that you won't earn that, then you also should hold enough stocks to get the higher expected (but uncertain) return. Of course there is a lot of uncertainty in the expected return of stocks over any time period.

As someone else pointed out, at a certain level of wealth relative to expenses, ability and need to take risk pull in opposite directions. If you estimate that you can live on a 1.5-2% withdrawal rate, then you have relatively low need to take risk, but you also have relatively high ability to take risk. You can then use your willingness to take risk to help figure out how much risk to take.

Say you can earn about 0.5% real on a 30-year TIPS ladder. At a 2% withdrawal rate, that would last you almost 58 years (57.68 = NPER(0.5%,-2%,1,0). Of course the TIPS ladder only extends to 30 years, but this calculation is just to provide an example of why you probably don't need to take any stock risk with that withdrawal rate.

We can also calculate that at 0.5% real return for 30 years, the TIPS ladder would support a withdrawal rate of about 3.6%: =-PMT(0.5%,30,1,0).

Some of the more conservative among us who estimate we can live on relatively low withdrawal rates, put enough into safe fixed income to meet our expected residual living expenses (after social security, pensions, etc.) for our expected lifetime (maybe adding a few years); i.e., we place a higher weight on low need to take risk than high ability to take risk. What we do with the rest doesn't matter so much, but certainly some or even much of it can be invested in stocks, perhaps for aspirational spending goals or for our heirs or charity.

Others among us, especially those with more of the Buffet faith in the long term prospects for stocks, go the other way, and have higher allocations to stocks, placing more weight on high ability to take risk than low need to take risk.

Kevin
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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by avalpert » Sun Oct 01, 2017 2:47 pm

Lauretta wrote:
Sun Oct 01, 2017 2:21 pm
Also, some people wrote on this Forum that your need falls as your wealth increases, and its the lowest of the 3 that will determine your decision.
Yes, need falls as wealth increases (unless you keep moving your goalposts) - not willingness which is driven by your temperament. That said, the lowest of the 3 does not necessary determine how much risk to take. Your need may be lower than your willingness, that doesn't mean you have to only take as much risk as you need so long as you don't exceed your ability (this falls apart in edge cases where one's ability approaches zero and the cost of the risk showing up gets so low relative to the status quo that taking the outsized risks becomes the right choice).

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by Big Dog » Sun Oct 01, 2017 2:50 pm

Having said that, let's say you have $500K in your 401K at 55 all in equities and the market drops 50%. Can you bear to see that $500K turn into $250K? Even though it may be a temporary drop, would you be able to handle it?
As I have learned on BH, the best answer is what helps you sleep at night.

But, to answer your hypo, I was ~55 in the last market crash, and I was 100% into equities. Slept like a baby, which is what I did in '87 and '00. (Yeah, I drink the Oracle kool aid ever since I bought into BRK.)

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by dbr » Sun Oct 01, 2017 2:53 pm

avalpert wrote:
Sun Oct 01, 2017 2:47 pm
Lauretta wrote:
Sun Oct 01, 2017 2:21 pm
Also, some people wrote on this Forum that your need falls as your wealth increases, and its the lowest of the 3 that will determine your decision.
Yes, need falls as wealth increases (unless you keep moving your goalposts) - not willingness which is driven by your temperament. That said, the lowest of the 3 does not necessary determine how much risk to take. Your need may be lower than your willingness, that doesn't mean you have to only take as much risk as you need so long as you don't exceed your ability (this falls apart in edge cases where one's ability approaches zero and the cost of the risk showing up gets so low relative to the status quo that taking the outsized risks becomes the right choice).
There is always that corner where need does not exist but ability and willingness do exist. One view is to break the tie by playing the trump card that one take no more risk than needed. Another approach is to review objectives. Other corners of the problem are need/no ability = screwed; need/ability = execute the plan; and no need/no ability = execute the plan.

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by Fallible » Sun Oct 01, 2017 3:17 pm

It may help for you to have Larry Swedroe's full definitions of ability, need, and willingness to take risk in the three blogs he wrote on the subjects. Here are excerpts from each with links to all following):

Ability:
"An investor’s ability to take risk is determined by four factors: (1) investment horizon; (2) stability of their earned income; (3) need for liquidity and (4) options that can be exercised should there be a need for a “Plan B” (a contingency plan that can be adopted should events occur that increase the likelihood of the plan failing to achieve it’s objective)."

Need:
"The need to take risk is determined by the rate of return required to achieve financial objectives. The greater the rate of return needed to achieve one's financial objective, the more risks with equities (and/or small and value stocks) one needs to take.

A critical part of the process is differentiating between real needs and desires.
These are very personal decisions, with no right answers."

Willingness:

"The first step in finding your willingness to take risk is to take what I refer to as the “stomach acid” test. Ask yourself this question: Do you have the fortitude and discipline to stick with your predetermined investment strategy when the going gets rough? Remember, when the only light at the end of the bear market tunnel seems to be the proverbial truck coming the other way, you’ll not only be required to avoid panicked selling, but you should be rebalancing your portfolio back to its targeted asset allocation. That will require you to buy stocks (which have been crashing) and selling bonds (which likely have been rising in value)."

https://www.cbsnews.com/news/asset-allo ... -you-take/
https://www.cbsnews.com/news/asset-allo ... -you-need/
https://www.cbsnews.com/news/asset-allo ... tolerance/

Also, Larry includes references to Buffett in the blogs. Although it doesn't pertain directly to some of the questions you've asked, as a new investor you might be interested in his book, Think, Act, and Invest Like Warren Buffett.

Besides reading the forum, have you read books listed in the forum's wiki under "Getting Started" and "Investing start-up kit":
https://www.bogleheads.org/wiki/Boglehe ... art-up_kit
Bogleheads® wiki | Investing Advice Inspired by Jack Bogle

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by Lauretta » Sun Oct 01, 2017 3:30 pm

Kevin M wrote:
Sun Oct 01, 2017 2:47 pm
I think Buffet conflates the low expected return of safe fixed income with risk. Safe fixed income is not risky in the long run, it is low return in the long run.

Investment risk is the uncertainty that you'll earn the expected return of the investment. Buffet, and many on this forum, seem to have 100% confidence, or close to it, that stocks will earn a real return higher than safe fixed income as long as your time horizon is long enough. That may be 10 years, or it may be 30 years. Buffet speaks in terms of a multi-decade time horizon, so I assume that for him at least 20 years is required to qualify as long term.

From this perspective, stocks may have a larger dispersion of returns over a long time horizon, but even the worst outcome is assumed to be better than the more certain outcome of fixed income. Some of us believe that this confidence is not warranted, and the paper referenced by Nisiprius is a good academic explanation of why.

We can use TIPS as a reference, since these have essentially no credit risk, no inflation risk, so if held to maturity, you will earn about the real yield (with some uncertainty due to reinvestment risk). Currently you earn a positive real yield on even a 5-year TIPS, at 0.24%, and the 30-year TIPS yield is 0.94%. Daily Treasury Real Yield Curve Rates. So currently, it is not true that fixed income offers no return, as long as your investment horizon is at least five years.

So to the extent that you are certain that stocks will earn more than 1% real over a 30-year time horizon, you should invest in stocks for that time horizon. If you are not so certain, and you don't have the need for a real return of more than 1% for a 30-year time horizon, the 30-year TIPS is a more appropriate investment. If you have the need for more than a 1% return, and you have the ability and willingness to take the risk that you won't earn that, then you also should hold enough stocks to get the higher expected (but uncertain) return. Of course there is a lot of uncertainty in the expected return of stocks over any time period.

As someone else pointed out, at a certain level of wealth relative to expenses, ability and need to take risk pull in opposite directions. If you estimate that you can live on a 1.5-2% withdrawal rate, then you have relatively low need to take risk, but you also have relatively high ability to take risk. You can then use your willingness to take risk to help figure out how much risk to take.

Say you can earn about 0.5% real on a 30-year TIPS ladder. At a 2% withdrawal rate, that would last you almost 58 years (57.68 = NPER(0.5%,-2%,1,0). Of course the TIPS ladder only extends to 30 years, but this calculation is just to provide an example of why you probably don't need to take any stock risk with that withdrawal rate.

We can also calculate that at 0.5% real return for 30 years, the TIPS ladder would support a withdrawal rate of about 3.6%: =-PMT(0.5%,30,1,0).

Some of the more conservative among us who estimate we can live on relatively low withdrawal rates, put enough into safe fixed income to meet our expected residual living expenses (after social security, pensions, etc.) for our expected lifetime (maybe adding a few years); i.e., we place a higher weight on low need to take risk than high ability to take risk. What we do with the rest doesn't matter so much, but certainly some or even much of it can be invested in stocks, perhaps for aspirational spending goals or for our heirs or charity.

Others among us, especially those with more of the Buffet faith in the long term prospects for stocks, go the other way, and have higher allocations to stocks, placing more weight on high ability to take risk than low need to take risk.

Kevin
Thank you so much, your explanation is very clear, I am learning a lot form this thread. I think that I may have been overly confident that provided your time horizon is long enough (say 20-30 yrs), stocks will have the best returns. I am going to find out more about the TIPS ladder you mention; Though for me, as an Italian investor, another reason for favouring stocks was that in Europe, unlike the US, we can't really trust that Government bonds are safe (and one would want bonds in one's currency to avoid currency risk). People think that there is a real risk that the Italian Government might default. And even holding German bonds would not be a completely safe bet (in the way the holding TIPs is for a US citizen) because who knows whether the Eurozone will last? If it doesn't, one would have currency risk because government debts would then be repaid in local currencies.
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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by FIREchief » Sun Oct 01, 2017 4:09 pm

alex_686 wrote:
Sun Oct 01, 2017 12:02 pm
Cash can be considered a special class of bonds and cash has historically had negative inflation adjusted returns.
Yep. Cash and US treasuries are both just paper IOUs created by the US government. The only real difference is that one pays no interest and the other pays a very small amount of interest (more paper) until maturity (when it can be replaced by a fresh piece of paper).
I am not a lawyer, accountant or financial advisor. Any advice or suggestions that I may provide shall be considered for entertainment purposes only.

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by Lauretta » Sun Oct 01, 2017 4:15 pm

Fallible wrote:
Sun Oct 01, 2017 3:17 pm
It may help for you to have Larry Swedroe's full definitions of ability, need, and willingness to take risk in the three blogs he wrote on the subjects. Here are excerpts from each with links to all following):

Ability:
"An investor’s ability to take risk is determined by four factors: (1) investment horizon; (2) stability of their earned income; (3) need for liquidity and (4) options that can be exercised should there be a need for a “Plan B” (a contingency plan that can be adopted should events occur that increase the likelihood of the plan failing to achieve it’s objective)."

Need:
"The need to take risk is determined by the rate of return required to achieve financial objectives. The greater the rate of return needed to achieve one's financial objective, the more risks with equities (and/or small and value stocks) one needs to take.

A critical part of the process is differentiating between real needs and desires.
These are very personal decisions, with no right answers."

Willingness:

"The first step in finding your willingness to take risk is to take what I refer to as the “stomach acid” test. Ask yourself this question: Do you have the fortitude and discipline to stick with your predetermined investment strategy when the going gets rough? Remember, when the only light at the end of the bear market tunnel seems to be the proverbial truck coming the other way, you’ll not only be required to avoid panicked selling, but you should be rebalancing your portfolio back to its targeted asset allocation. That will require you to buy stocks (which have been crashing) and selling bonds (which likely have been rising in value)."

https://www.cbsnews.com/news/asset-allo ... -you-take/
https://www.cbsnews.com/news/asset-allo ... -you-need/
https://www.cbsnews.com/news/asset-allo ... tolerance/

Also, Larry includes references to Buffett in the blogs. Although it doesn't pertain directly to some of the questions you've asked, as a new investor you might be interested in his book, Think, Act, and Invest Like Warren Buffett.

Besides reading the forum, have you read books listed in the forum's wiki under "Getting Started" and "Investing start-up kit":
https://www.bogleheads.org/wiki/Boglehe ... art-up_kit
Thank you, I have read the 3 pieces by Mr Swedroe - very cleary written - I haven't read those books but I'm going to read the one by Bernstein tonight and ordering the others. I had done some reading of academic papers on stocks (because I have an academic background, though it is in science) but I am realising that I need to think more clearly about the most important thing: the relationship between one's objectives and the way one invests in order to achieve them.
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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by avalpert » Sun Oct 01, 2017 4:18 pm

FIREchief wrote:
Sun Oct 01, 2017 4:09 pm
alex_686 wrote:
Sun Oct 01, 2017 12:02 pm
Cash can be considered a special class of bonds and cash has historically had negative inflation adjusted returns.
Yep. Cash and US treasuries are both just paper IOUs created by the US government. The only real difference is that one pays no interest and the other pays a very small amount of interest (more paper) until maturity (when it can be replaced by a fresh piece of paper).
This is not an accurate way to look at currency vs. sovereign bonds. Currency is not an IOU from the government, it is legal tender as defined by the government for use in paying them but it isn't an IOU. The government owes you nothing for you holding it.

A bond on the other hand is a promise to pay you interest in exchange for you lending them money. You give the government money, they pay you back with interest - at least that can more be called an IOU

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by dbr » Sun Oct 01, 2017 4:32 pm

Lauretta wrote:
Sun Oct 01, 2017 4:15 pm
Thank you, I have read the 3 pieces by Mr Swedroe - very cleary written - I haven't read those books but I'm going to read the one by Bernstein tonight and ordering the others. I had done some reading of academic papers on stocks (because I have an academic background, though it is in science) but I am realising that I need to think more clearly about the most important thing: the relationship between one's objectives and the way one invests in order to achieve them.
[/quote]

If you are a reader by nature then you might try the book Unveiling the Retirement Myth by Jim Otar available at this site, also his calculator which may be informative: http://www.retirementoptimizer.com/

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by RadAudit » Sun Oct 01, 2017 4:41 pm

Lauretta wrote:
Sun Oct 01, 2017 1:17 pm
RadAudit wrote:
Sun Oct 01, 2017 1:04 pm
But, I believe it means that if you have reached your goal you can dial back the degree of risk in your portfolio.
But then if you had enough money like the couple in Bernstein's story, what would you do to stop taking risks? Go to cash? Then you'd have inflation risk... :( Perhaps buy TIPs?
Sorry, I was away from the keyboard for a bit. Fortunately, BHers way more qualified than I am answered most of the question a lot better than I could.

But, on a personal note since you asked, I doubt if I'd ever be totally out of stocks. Primarily because I don't have $13 mil - heck, I don't have $3 mil - and I do have a few other goals besides just making the money last only as long as I live. Some on this board argue for a stock % as low as 30% of the portfolio for a stage later in life and to hedge against the possibility of inflation. (Haven't got that old or that low, yet.) Haven't gone all the way to TIPS, either. And to really confuse things I have both domestic and internal stocks and bonds via funds. The international bonds are hedged against my local currency. (Total, stock and bonds - five funds) Bonds and TIPS can cover about 20 years of residual living expenses. No, I don't have a rationally defensible reason for this approach. However, the current asset allocation does feel about right although it doesn't maximize returns.
Last edited by RadAudit on Sun Oct 01, 2017 4:59 pm, edited 2 times in total.
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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by snarlyjack » Sun Oct 01, 2017 4:48 pm

Lauretta,

Here is a article on Warren Buffett call
on the 2117 (100 years) Dow being at 1 Million.

If only someone could be like Rip Van Winkle.

Enjoy...

https://www.usatoday.com/story/money/20 ... 707440001/

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by FIREchief » Sun Oct 01, 2017 5:08 pm

avalpert wrote:
Sun Oct 01, 2017 4:18 pm
FIREchief wrote:
Sun Oct 01, 2017 4:09 pm
alex_686 wrote:
Sun Oct 01, 2017 12:02 pm
Cash can be considered a special class of bonds and cash has historically had negative inflation adjusted returns.
Yep. Cash and US treasuries are both just paper IOUs created by the US government. The only real difference is that one pays no interest and the other pays a very small amount of interest (more paper) until maturity (when it can be replaced by a fresh piece of paper).
This is not an accurate way to look at currency vs. sovereign bonds. Currency is not an IOU from the government, it is legal tender as defined by the government for use in paying them but it isn't an IOU. The government owes you nothing for you holding it.

A bond on the other hand is a promise to pay you interest in exchange for you lending them money. You give the government money, they pay you back with interest - at least that can more be called an IOU
Well, if you want to get all technical about it, then I'll agree with you. 8-)

That said, if the fed decided to start paying off maturing treasuries with freshly printed paper money, they would just be giving people a piece of paper that paid zero percent interest in exchange for one that paid a very small amount of interest. Isn't this essentially what quantitative easing consisted of?
I am not a lawyer, accountant or financial advisor. Any advice or suggestions that I may provide shall be considered for entertainment purposes only.

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by TD2626 » Sun Oct 01, 2017 5:29 pm

nisiprius wrote:
Sun Oct 01, 2017 12:53 pm
Lauretta, the thing I would point out is that the proposition that stocks are not risky, or less risky, or become less risky in the long run is controversial. Some say so, some do not. So do not be too quick to take it as simple fact. This point is frequently debated in this forum. I don't want to insist strongly on "what point of view is right" but I do want you to at least read the summary of an academic paper. The meaning and implications of this paper have been debated in this forum, as well as the meaning of "risk," and what Buffett is actually saying, and so forth and so on.

Pastor, Lubos and Stambaugh, Robert F. (2011), Are Stocks Really Less Volatile in the Long Run?
According to conventional wisdom, annualized volatility of stock returns is lower over long horizons than over short horizons, due to mean reversion induced by return predictability. In contrast, we find that stocks are substantially more volatile over long horizons from an investor's perspective. This perspective recognizes that parameters are uncertain, even with two centuries of data, and that observable predictors imperfectly deliver the conditional expected return. Mean reversion contributes strongly to reducing long-horizon variance, but it is more than offset by various uncertainties faced by the investor, especially uncertainty about the expected return. The same uncertainties reduce desired stock allocations of long-horizon investors contemplating target-date funds.
Thanks for the link to the paper. I read through it, and it was interesting. Another paper, by Fama and French, is here:https://papers.ssrn.com/sol3/papers.cfm ... id=2973516. It discusses how returns can be quite uncertain over the long run.

However, I feel that one can be missing the point. I feel stocks are (based on my personal, yet debatable, interpretations of "risk", "return", and "long run"), that stocks are safer over the long run, at least for someone in my particular circumstances.

The first sentence in the study by Pastor, Lubos and Stambaugh, Robert F. (2011), "Are Stocks Really Less Volatile in the Long Run?" clearly says that
Conventional wisdom views stock returns as less volatile over longer investment horizons.
While the authors disagree with this conventional wisdom, they admit what the conventional wisdom is. Anyone arguing that stocks are more risky over the long run are going in the face of this conventional wisdom and should shoulder the lion's share of the burden of proof for their theories.

Here's an example of how I view things: If (based on long-run historical data) the average annual return is, say, 10% and the standard deviation of the annual returns are 20%, after 10 years of investing the standard deviation would be (based on the standard error/standard deviation of the mean formula) 20%*(1/sqrt(10)). After 100 years, the standard deviation of the CAGR would be 1/sqrt(100) or 1/10th of the single-year's standard deviation. Note that the reduction in risk via the 1/sqrt(N) formula shows a reduction in return volatility in percent, not a reduction in portfolio values in dollars.

This all, of course assumes risk is defined as standard deviation. I believe that risk is best defined as standard deviation. There are issues with the Gaussian approximation (kurtosis and skewedness, autocorrelation, etc). However, these issues are relatively small, and in my opinion it is reasonable to approximate them to zero. Further, defining risk as standard deviation is reasonable because other risk measures (such as downside risk) fail to account for the full spectrum of uncertainty in returns.

For the purposes of this paragraph, assume risk somehow does increase over the long run for risky assets. If this were the case, an investor with an infinite or very long time horizon (someone setting aside savings to be passed on to grandchildren), or someone working with an endowment) would want to be in 100% cash. This makes no sense. Here is where Buffet's ideas of risk would be invoked - with 100% cash risk is avoided but real return is also minimized.

The way out, in my opinion, is to collect more historical data. With very, very, very long run historical data (like in this thread:viewtopic.php?t=227268), one can hopefully reduce uncertainty in MPT model inputs (e.g. expected values for risks, returns, and correlations) enough that the "stocks are less risky over the long run" approximation is valid.

I do agree, though, that there is a legitimate controversy over whether stocks are more or less risky over the long run. I think that the takeaway is that for long-horizon investors, having at least some in bonds is reasonable. This article (http://www.efficientfrontier.com/ef/402/2cent.htm) also discusses this. I feel that even those with a high risk tolerance and a long horizon should take the ideas from these papers and essays into consideration and at least consider a 80/20 or 90/10 portfolio instead of betting everything on equity market beta with a 100/0 portfolio.

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by onthecusp » Sun Oct 01, 2017 5:37 pm

Having scanned a lot of really interesting back and forth in this thread it appears to me that the OP is oscillating between various "all-in" supposed "best" investments for their situation. I would have them consider that balanced portfolios are ways to address a variety of risks. Pretty much the ones you have been talking about.

We don't know which risk will rear up next but one or three probably will come into play over the next few decades. TIPS and their equivalent sound risky to me as the yield can be negative, bonds are risky, stocks are generally agreed to be risky except when you can look at them as Buffet does, cash is certainly risky over the long run but Buffet in one of his annual papers said Berkshire Hathaway holds about a Billion dollars in cash and if I recall correctly that was considered their minimum! But a portfolio of TIPS, Bonds, Stocks, and cash for short term needs sounds not so risky and I expect good growth over decades. It is the proportions that can be adjusted to your needs.

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by dbr » Sun Oct 01, 2017 5:51 pm

TD2626 wrote:
Sun Oct 01, 2017 5:29 pm
Here's an example of how I view things: If (based on long-run historical data) the average annual return is, say, 10% and the standard deviation of the annual returns are 20%, after 10 years of investing the standard deviation would be (based on the standard error/standard deviation of the mean formula) 20%*(1/sqrt(10)). After 100 years, the standard deviation of the CAGR would be 1/sqrt(100) or 1/10th of the single-year's standard deviation. Note that the reduction in risk via the 1/sqrt(N) formula shows a reduction in return volatility in percent, not a reduction in portfolio values in dollars.
You have to add to this analysis that the annualized standard deviation compounds for N years producing a standard deviation of end point wealth that increases as sqrt(N). You also have to add to this the fact that the average return is positive (upward trend in wealth with years) and then decide if the results in the end are a problem for the prospective investor or not. The result depends on what is wanted and on the understanding of what is expected.

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by Lauretta » Sun Oct 01, 2017 5:59 pm

onthecusp wrote:
Sun Oct 01, 2017 5:37 pm
Having scanned a lot of really interesting back and forth in this thread it appears to me that the OP is oscillating between various "all-in" supposed "best" investments for their situation. I would have them consider that balanced portfolios are ways to address a variety of risks. Pretty much the ones you have been talking about.

We don't know which risk will rear up next but one or three probably will come into play over the next few decades. TIPS and their equivalent sound risky to me as the yield can be negative, bonds are risky, stocks are generally agreed to be risky except when you can look at them as Buffet does, cash is certainly risky over the long run but Buffet in one of his annual papers said Berkshire Hathaway holds about a Billion dollars in cash and if I recall correctly that was considered their minimum! But a portfolio of TIPS, Bonds, Stocks, and cash for short term needs sounds not so risky and I expect good growth over decades. It is the proportions that can be adjusted to your needs.
Thank you for this interesting point; this makes sense to me as particularly in Europe bonds are not necessarily safer; however doesn't the 'willingness, ability and need to take risk' argument implictly equate stocks with risk? (i.e. the couple with 13M would have been better off owning less stock=taking less risk). Don't know if this remak makes sense - it's one in the morning here and I'm off to sleep, but thanks everyone for these great comments - I'm learning a lot on this Forum.
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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by TD2626 » Sun Oct 01, 2017 6:37 pm

dbr wrote:
Sun Oct 01, 2017 5:51 pm
TD2626 wrote:
Sun Oct 01, 2017 5:29 pm
Here's an example of how I view things: If (based on long-run historical data) the average annual return is, say, 10% and the standard deviation of the annual returns are 20%, after 10 years of investing the standard deviation would be (based on the standard error/standard deviation of the mean formula) 20%*(1/sqrt(10)). After 100 years, the standard deviation of the CAGR would be 1/sqrt(100) or 1/10th of the single-year's standard deviation. Note that the reduction in risk via the 1/sqrt(N) formula shows a reduction in return volatility in percent, not a reduction in portfolio values in dollars.
You have to add to this analysis that the annualized standard deviation compounds for N years producing a standard deviation of end point wealth that increases as sqrt(N). You also have to add to this the fact that the average return is positive (upward trend in wealth with years) and then decide if the results in the end are a problem for the prospective investor or not. The result depends on what is wanted and on the understanding of what is expected.
So if I am reading this right - with, say, 10,000 Monte Carlo simulations:
-Risk as measured by the standard deviation of CAGR decreases by 1/sqrt(N)
-However, that CAGR compounds for N years
-So, the standard deviation of final portfolio value (in dollars) divided by average final portfolio value (in dollars) increases as sqrt(N)

Is this last point correct? If so, and if risk is tied to uncertainty in dollar value of the portfolio, then risk could by that definition increase. One would have to measure risk by uncertanty in the CAGR in order to claim risk decreases via a 1/sqrt(N) law, then.
Last edited by TD2626 on Sun Oct 01, 2017 9:40 pm, edited 1 time in total.

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by packer16 » Sun Oct 01, 2017 6:43 pm

IMO one to look at this question is how risk averse are you. If you are risk averse, then the the willingness, ability & need framework is applicable if you are not then Buffett's framework is more applicable. As to folks using math to prove stocks are more volatile than bonds over the long-term are letting math & risk aversion speak versus the data. When the data shows your conclusions are wrong you do not change the data based upon theoretical constructs to prove you are correct (you can see this in some of the factor work also), which IMO is what the above study does. If you want to use a risk averse framework do so & do not try to prove the data is wrong, you only look like a fool doing it.

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by dbr » Sun Oct 01, 2017 9:06 pm

TD2626 wrote:
Sun Oct 01, 2017 6:37 pm

So if I am reading this right - with, say, 10,000 Monte Carlo simulations:
-Risk as measured by the standard deviation of CAGR decreases by 1/sqrt(N)
-However, that CAGR compounds for N years
-So, the standard deviation of final portfolio value (in dollars) divided by average final portfolio value (in dollars) increases as sqrt(N)

Is this last point correct? If so, and if risk is tied to uncertanty in dollar value of the portfolio, then risk could by that definition decrease. One would have to measure risk by uncertanty in the CAGR in order to claim risk decreases via a 1/sqrt(N) law, then.
You mean increase, but yes you have the right statement. A discussion is here: http://www.norstad.org/finance/risk-and-time.html

However, one might note that if the question is how likely is it that a riskier higher returning portfolio would result in more wealth over time than a less risky lower returning portfolio, then the answer to that is said chances could increase over time as the entire spread of the higher returning portfolio trends to higher values than the entire spread of the lower one even if those spreads are increasing. If you want to see this in real data go run FireCalc with no withdrawals, perhaps a thirty year duration, and various selections of portfolio asset allocation and see how things would have evolved over that 30 year period in a hundred or so actual starting years in history in the United States: https://www.firecalc.com/

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by Fallible » Sun Oct 01, 2017 10:41 pm

Lauretta wrote:
Sun Oct 01, 2017 4:15 pm
Fallible wrote:
Sun Oct 01, 2017 3:17 pm
It may help for you to have Larry Swedroe's full definitions of ability, need, and willingness to take risk in the three blogs he wrote on the subjects. Here are excerpts from each with links to all following):
...
Besides reading the forum, have you read books listed in the forum's wiki under "Getting Started" and "Investing start-up kit":
Thank you, I have read the 3 pieces by Mr Swedroe - very cleary written - I haven't read those books but I'm going to read the one by Bernstein tonight and ordering the others. I had done some reading of academic papers on stocks (because I have an academic background, though it is in science) but I am realising that I need to think more clearly about the most important thing: the relationship between one's objectives and the way one invests in order to achieve them.

Yes, that is most important, your own unique objectives carried out in a "workable" plan, the first principle in the Bogleheads' philosophy.
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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by TD2626 » Mon Oct 02, 2017 1:04 am

dbr wrote:
Sun Oct 01, 2017 9:06 pm
You mean increase, but yes you have the right statement. A discussion is here: http://www.norstad.org/finance/risk-and-time.html
Yes, I meant increase; I corrected the wording of my post.
I read the Norstad paper - It was quite interesting.
dbr wrote: However, one might note that if the question is how likely is it that a riskier higher returning portfolio would result in more wealth over time than a less risky lower returning portfolio, then the answer to that is said chances could increase over time as the entire spread of the higher returning portfolio trends to higher values than the entire spread of the lower one even if those spreads are increasing. If you want to see this in real data go run FireCalc with no withdrawals, perhaps a thirty year duration, and various selections of portfolio asset allocation and see how things would have evolved over that 30 year period in a hundred or so actual starting years in history in the United States: https://www.firecalc.com/

After thinking about it for a while, I feel that it's all a matter of how one defines "risk". If risk is defined as the standard deviation of CAGR, then stocks are less risky over the long run... but if you use other definitions of risk (such as "risk of needing to eat dog food") then you get a different conclusion.

Basically, I think that this is a difficult to solve. No one should claim there's no room for debate. I think the main takeaway is that it is hard to know for certain where one's allocation should be, and that allocations should not be 100/0 or 0/100. Having a more balanced portfolio is in general warranted.

Also -- if stocks are riskier in over the long run based on one's definition of risk, what would the optimal stock allocation be as a function of time horizon? One option could be something roughly like this:

Code: Select all

Time Horizon (years)	Equity Allocation (%)
0-2			0
3-5			20
5-10			40
10-20			60
20-30			70
30-40			85
40-50			80
50-100			75
100-200			70
Infinity		60
(Note- these are hypothetical numbers to probe an idea regarding the general shape of the equity allocation vs time horizon curve - it's intended for the sake of debate only. It would change for individuals based on their risk tolerance.)

Essentially equity allocation would be at a very low value for someone with a low time horizon (say, <5-10 years) so that the investor doesn't risk money needed relatively soon. The equity allocation would be highest for someone with a moderately long term time horizon (20-50 years) but would decline as time horizon increases beyond that to account for stocks being riskier over longer periods (if an investor believes that is the case).

Is this model reasonable? Would this explain the general phenomenon of investors managing endowments (with a time horizon of infinity) being at 60/40 while Target Date investors with 40 or 50 year horizons have far higher equity allocations?


I still think that based on how I define risk (STDEV of CAGR), stocks are less risky. My concerns with the idea that stocks are more risky over longer horizons are as follows:

1. If stocks are more risky over long horizons, does that mean endowments with infinite horizons should be 100% cash? That would be unreasonable, of course - and would expose the funds to shortfall risk.

2. If stocks are more risky over long horizons, this would (in the reductio ad absurdum case) seem to imply that a short-horizon should have a high equity allocation relative to a long-horizon investor. Surely one wouldn't want to put next month's rent or mortgage payment in stocks - cash is the only acceptable place to put near-term expenses.

3. The idea that stocks are less risky over long periods is very firmly held by the broad investment community. This is a traditional, consensus idea... and it's one reason why long-horizon investors choose 90%+ equity allocations via target-date funds. Going against the broad consensus is unsettling.

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by dbr » Mon Oct 02, 2017 7:35 am

You can define risk in any way you want. The facts about how stocks behave are not affected by a definition.

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by onthecusp » Mon Oct 02, 2017 10:14 am

Lauretta wrote:
Sun Oct 01, 2017 5:59 pm
onthecusp wrote:
Sun Oct 01, 2017 5:37 pm
Having scanned a lot of really interesting back and forth in this thread it appears to me that the OP is oscillating between various "all-in" supposed "best" investments for their situation. I would have them consider that balanced portfolios are ways to address a variety of risks. Pretty much the ones you have been talking about.

We don't know which risk will rear up next but one or three probably will come into play over the next few decades. TIPS and their equivalent sound risky to me as the yield can be negative, bonds are risky, stocks are generally agreed to be risky except when you can look at them as Buffet does, cash is certainly risky over the long run but Buffet in one of his annual papers said Berkshire Hathaway holds about a Billion dollars in cash and if I recall correctly that was considered their minimum! But a portfolio of TIPS, Bonds, Stocks, and cash for short term needs sounds not so risky and I expect good growth over decades. It is the proportions that can be adjusted to your needs.
Thank you for this interesting point; this makes sense to me as particularly in Europe bonds are not necessarily safer; however doesn't the 'willingness, ability and need to take risk' argument implictly equate stocks with risk? (i.e. the couple with 13M would have been better off owning less stock=taking less risk). Don't know if this remak makes sense - it's one in the morning here and I'm off to sleep, but thanks everyone for these great comments - I'm learning a lot on this Forum.

Yes, I agree the w / a / n "formula" as it is generally discussed looks at stocks as high risk/high reward and bonds/TIPS/cash as lower risk lower reward. Lower risk as in lower volatility, but not no risk or even less likely risks. Volatility is not the only kind of risk, but it is a common problem within investing and is what is generally addressed in the math around financial risk. Cash may not be volatile, and currently inflation seems to be a low risk, but it is nearly 100% certain.

The w / a / n "formula is all in the context of optimizing a diversified asset allocation for your particular circumstances and psychology. It is almost never about going to one extreme or another and putting everything in TIPS or everything in stocks. So, in my opinion, and not knowing anything else about the 13M couple, they would probably be better off with less stock if their current allocation is over 90% stock. They would NOT be better off with less stock if their current allocation is less than 10%. That leaves a wide area in the middle where individual circumstances and personal tendencies rule.

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by dbr » Mon Oct 02, 2017 10:25 am

onthecusp wrote:
Mon Oct 02, 2017 10:14 am


Yes, I agree the w / a / n "formula" as it is generally discussed looks at stocks as high risk/high reward and bonds/TIPS/cash as lower risk lower reward. Lower risk as in lower volatility, but not no risk or even less likely risks. Volatility is not the only kind of risk, but it is a common problem within investing and is what is generally addressed in the math around financial risk. Cash may not be volatile, and currently inflation seems to be a low risk, but it is nearly 100% certain.
That is correct. It is a method designed to answer the specific question of what the balance should be between high returning high risk investments (stocks) and low returning low risk investments (bonds).

An example of an important risk question it does not answer is how does asset allocation affect the chances of running out of money during retirement while withdrawing to support expenses. The answer to that question exists and has some differences from n/a/w based on risk as volatility.

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by halfnine » Mon Oct 02, 2017 12:34 pm

Lauretta wrote:
Sun Oct 01, 2017 12:30 pm
dbr wrote:
Sun Oct 01, 2017 11:59 am
I would say Mr. Buffett has a different idea regarding what investing is all about, specifically that it is a business enterprise and not how an individual goes about saving excess income for later consumption, aka retirement. As such his ideas of risk are not contradictory to n/a/w so much as orthogonal to it.

That said I think one can rationalize n/a/w to his ideas of what is risky. Need translates into what return is needed to meet objectives. Bonds in Buffetts world do not produce adequate return, so one needs investments that do, aka stocks. Investments that are not expected to meet objectives are risky. N/a/w agrees with that. Probably the point of departure for Buffett is about ability and willingness. Buffett has an abiding faith in the soundness and prospects for the American economy which says that investing in stocks of well chosen American companies will generate long term rewards. As long as one keeps one's financial situation on a sound basis including preservation of funds for liquidity, not making stupid deals, and not overspending one's resources, one has the ability to take risk in stocks. Finally, and crucially, one has to invest for the long run and be prepared for volatility. In other words willingness means development of the ability to take the long view, not panic, and stick to a plan.

Maybe that helps.
Thanks for the explanations. :happy I guess the tricky bit for me is to clearly understand the 'need' part. If I calculate my total assets including the rental properties I have (together with the ETFs I recently bought aftr selling some real estate, and the cash), then my annual expenses are maybe 1,5-2% of that. Actually this is mainly because in Europe we tend to live on much less than in the US! I am 48 so I guess that I can perhaps retire (I'm just not confident enough to take the step!) so that I can do things that I really care about now, not worrying about income. But concerning my investments, should I be focused on minimising the risk that e.g. my savings will lose purchasing power over time, or should I worry more about DD risk? The objective is of course to be able to support myself in retirement through rental income (about 1/3 of my worth) and the liquid assets I have.
I don't view any asset as "riskless". If you have rental properties, stocks and fixed income and diversify evenly among them it would be hard to argue against. For an Italian, personally, I'd probably want global equities. For fixed income...global bonds and CDs might also be a worthwhile deviation from 100% EU bonds.

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Re: Buffett's idea of risk vs risk as in the formula: 'willingness, ability and need'

Post by Lauretta » Mon Oct 02, 2017 1:01 pm

halfnine wrote:
Mon Oct 02, 2017 12:34 pm
Lauretta wrote:
Sun Oct 01, 2017 12:30 pm
dbr wrote:
Sun Oct 01, 2017 11:59 am
I would say Mr. Buffett has a different idea regarding what investing is all about, specifically that it is a business enterprise and not how an individual goes about saving excess income for later consumption, aka retirement. As such his ideas of risk are not contradictory to n/a/w so much as orthogonal to it.

That said I think one can rationalize n/a/w to his ideas of what is risky. Need translates into what return is needed to meet objectives. Bonds in Buffetts world do not produce adequate return, so one needs investments that do, aka stocks. Investments that are not expected to meet objectives are risky. N/a/w agrees with that. Probably the point of departure for Buffett is about ability and willingness. Buffett has an abiding faith in the soundness and prospects for the American economy which says that investing in stocks of well chosen American companies will generate long term rewards. As long as one keeps one's financial situation on a sound basis including preservation of funds for liquidity, not making stupid deals, and not overspending one's resources, one has the ability to take risk in stocks. Finally, and crucially, one has to invest for the long run and be prepared for volatility. In other words willingness means development of the ability to take the long view, not panic, and stick to a plan.

Maybe that helps.
Thanks for the explanations. :happy I guess the tricky bit for me is to clearly understand the 'need' part. If I calculate my total assets including the rental properties I have (together with the ETFs I recently bought aftr selling some real estate, and the cash), then my annual expenses are maybe 1,5-2% of that. Actually this is mainly because in Europe we tend to live on much less than in the US! I am 48 so I guess that I can perhaps retire (I'm just not confident enough to take the step!) so that I can do things that I really care about now, not worrying about income. But concerning my investments, should I be focused on minimising the risk that e.g. my savings will lose purchasing power over time, or should I worry more about DD risk? The objective is of course to be able to support myself in retirement through rental income (about 1/3 of my worth) and the liquid assets I have.
I don't view any asset as "riskless". If you have rental properties, stocks and fixed income and diversify evenly among them it would be hard to argue against. For an Italian, personally, I'd probably want global equities. For fixed income...global bonds and CDs might also be a worthwhile deviation from 100% EU bonds.
thanks for your input. Yes I have global equities - the only reason I have somewhat overweighted Italy relative to market cap (but I have done that too for e.g. Emerging markets) are the lower valuations (I saw a video in which Shiller argued in favour of Italy). Concerning bonds at present I don't have any: I have a barbell portfolio of stocks+cash. Bond yields in the Eurozone are negative for AAA bonds of maturity less than 6,5 years, so if I bought an all-maturity ETF I would be automatically losing money on all the shorter term bonds within it! I really cannot understand why anyone would want to do that! Ditto for a global currency hedged ETF, because the cost of hedging is related to interest rates differentials. (I understood that if you don't currency hedge your bonds you introduce currency risk which somewhat defies the purpose of holding bonds, since they are meant amongst other things to give greater stability to your portfolio. So yes, if short term rates in EU go up it will make sense to buy a global currency hedged ETF. Otherwise, I had the thought of perhaps buying some longer term EU bonds, which would at least have the purpose of hedging the stock part of my portfolio (if I correctly understand the use of bonds in e.g. risk parity portfolios)
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