Need, ability and willingness to take risk

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
pkcrafter
Posts: 12830
Joined: Sun Mar 04, 2007 12:19 pm
Location: CA
Contact:

Re: Need, ability and willingness to take risk

Post by pkcrafter » Mon Jan 06, 2014 9:53 pm

Rodc, thank you for the reply
Rodc wrote:Paul,

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

I would say a young person has no idea what return they need because the future is so uncertain. They have no clue what they will need for income in 50 years. Or what they will earn over the decades in income or investment returns. I agree that most young people should have a decent amount of stocks because historically (and reasonably expected in the future) that will pay off well, but not because they can specify some particular expected needed return.

Rod, I specifically did not mention a target because I agree that one cannot dial in a return nor a final portfolio amount. All I'm saying is young investors have a need to take stock risk because it's very difficult to accumulate enough for retirement by investing in only cash or bonds, or by saving enough.

You start with a reasonable generic portfolio if you are a reasonably generic person and watch what happens. If all goes well, great, replan every 10 years or so and all is good. If things do not go well, you start trying to save more and/or plan to work longer, you don't increase your "needed" return (which is just a mental trick to tell yourself to take more risk). Same really at some level for most people of any age, subject to the ability and willingness to bear the risk.

Absolutely agree.

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

Again, my simple statement is young investors have a need to take risk. I'll narrow that to some measured amount of risk.

I guess that is another significant part of my objection: you simple cannot start with a return target and engineer a portfolio to hit it. And that to my mind is what the need part of need, willingness and ability suggests or likely suggests to many.

No, I am not suggesting anything like that. I'm saying if there is ever a time when an investor has a valid need to take risk, it is when he/she is young.

Far better to my mind is using willingness and ability to build your portfolio and then assess the likely range of outcomes and make a plan where you will be fine if you end up on the low side (may be hard to make a plan that works in the very worst case, but then that is pretty true of much of life.)

OK, I've discussed need, but in reality sound investment strategy ends up being a reasoned compromise between need, ability and willingness. However, willingness cannot be overridden by need or ability.

I hope I have presented a clearer picture of what I was trying to say. My feeling is taking risk is necessaryadvantageous and justified when the time horizon is long, ability is acceptable, and willingness is not exceeded. Basing the amount of risk one takes based simply on need can be very dangerous. For instance, I need a 10% return to meet my goal in 15 years. Maybe it's not obvious to some, but dialing in a return and increasing risk to get it will probably result in a far worse situation than had it not been tried.

Paul

When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

pkcrafter
Posts: 12830
Joined: Sun Mar 04, 2007 12:19 pm
Location: CA
Contact:

Re: Need, ability and willingness to take risk

Post by pkcrafter » Mon Jan 06, 2014 11:06 pm

richard wrote:
pkcrafter wrote:Bob k and Rodc,

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

I don't disagree.

There are no guarantees that you will be rewarded for taking more risk, even if you hold for a very long time.
True. The quote is Larry's, not mine. I fully agree with your assessment. Please see my reply to Rodc for a better understanding of what I'm saying. I'm only saying young investors have a need to take risk--calculated risk, and it must be balanced against ability and willingness.

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

pkcrafter
Posts: 12830
Joined: Sun Mar 04, 2007 12:19 pm
Location: CA
Contact:

Re: Need, ability and willingness to take risk

Post by pkcrafter » Tue Jan 07, 2014 10:57 am

bobcat2 wrote:
Fallible wrote:[W]ouldn't risk tolerance be as important or more so than financial capacity? If a new investor has the financial means to invest but not the emotional tolerance for the stocks needed to achieve his/her goals, isn't it better for an advisor to suggest at least starting out with a lower stock allocation to lessen the chance the client will suffer sleepless nights and/or panic and bail out in bad markets? Isn't the main goal, the bottom line, to craft an AA that will allow the investor to stay the course even if it requires a longer term to meet his goals?
No. Nearly all young people are constrained by their risk capacity. Most young people (at least 90%) have credit card, auto, and often student loan debt, or even worse payday loans and their ilk, insecure jobs and career paths, and little or no emergency funds, i.e. most young people don't have much risk capacity. Given how wide spread constrained risk capacity is, and also the fact that it is easier to measure, we start with risk capacity.

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

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

BobK
Bob, basically nothing is going to work if risk tolerance is breached. Moving out of stocks can be very damaging. It converts temporary loss to permanent loss--shallow risk to deep risk.

Larry Swedroe:
what I have learned in over 15 years of providing advice to individual and institutional investors is that ultimately the greatest determinant of success or failure of a plan is human behavior.

For investors who aren't extremely risk sensitive, it all comes down to a balance and compromise of need, ability and tolerance. For those who are less risk tolerant than average, risk tolerance limits have to be respected above all.

http://www.cbsnews.com/news/why-you-nee ... ment-plan/

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

User avatar
bobcat2
Posts: 5202
Joined: Tue Feb 20, 2007 3:27 pm
Location: just barely Outside the Beltway

Re: Need, ability and willingness to take risk

Post by bobcat2 » Tue Jan 07, 2014 12:05 pm

basically nothing is going to work if risk tolerance is breached. Moving out of stocks can be very damaging. It converts temporary loss to permanent loss--shallow risk to deep risk.
Not moving out of stocks can also be very damaging. Don't take my word for it, ask any Japanese investor who stayed heavily invested in the Japanese stock market from 1990-2008. The real cumulative equity loss was about 70%. Over that same period Japanese bonds roughly doubled in real value. Staying in stocks destroyed portfolios. There is nothing wrong with deciding that your prior strategy of holding a large equity position was a poor decision, admitting your mistake, and lowering your equity position to a more prudent lower level.

JM Keynes:
“When I’m wrong, I change my mind. What do you do?”


Link - http://quoteinvestigator.com/2011/07/22 ... ange-mind/

BobK
In finance risk is defined as uncertainty that is consequential (nontrivial). | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.

technovelist
Posts: 2917
Joined: Wed Dec 30, 2009 9:02 pm
Contact:

Re: Need, ability and willingness to take risk

Post by technovelist » Tue Jan 07, 2014 1:00 pm

bobcat2 wrote:pkcrafter writes.
I think need to take risk is best understood when thinking of the returns over 30 years in so called safe investments vs stocks. In fact, safe investments are not safe, they are very risky when one realizes goals cannot be met with safe investments.
Once more time. If you are falling short of your retirement income goal there are only three ways to improve the chances of getting there: Save more (and consume less) now, work longer (retire later), or take more risk (and accept a larger shortfall in the event you do not succeed).

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

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

BobK
Then there are no safe investments, because no investment has a known outcome; every investment has risk of one type or another (or more than one type).

Which is just another reason to be diversified across investment categories, jurisdictions, tax-deferral, and every other dimension that one can think of.
In theory, theory and practice are identical. In practice, they often differ.

User avatar
bobcat2
Posts: 5202
Joined: Tue Feb 20, 2007 3:27 pm
Location: just barely Outside the Beltway

Re: Need, ability and willingness to take risk

Post by bobcat2 » Tue Jan 07, 2014 1:50 pm

Then there are no safe investments
There are relatively safe investments. I-bonds are one. TIPS bonds held to maturity are another. Nominal Treasuries held to maturity are another, if the liability being matched is nominal. If you think holding a five year TIPS bond to maturity to fund a real liability due in five years is as risky as holding a stock mutual fund for five years to fund the liability, then we live on different financial planets. :)

BobK
In finance risk is defined as uncertainty that is consequential (nontrivial). | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.

technovelist
Posts: 2917
Joined: Wed Dec 30, 2009 9:02 pm
Contact:

Re: Need, ability and willingness to take risk

Post by technovelist » Tue Jan 07, 2014 2:13 pm

bobcat2 wrote:
Then there are no safe investments
There are relatively safe investments. I-bonds are one. TIPS bonds held to maturity are another. Nominal Treasuries held to maturity are another, if the liability being matched is nominal. If you think holding a five year TIPS bond to maturity to fund a real liability due in five years is as risky as holding a stock mutual fund for five years to fund the liability, then we live on different financial planets. :)

BobK
Different investments have different risks, but they all have risk of one or more types. I think that is true on pretty much any financial planet. :-)
In theory, theory and practice are identical. In practice, they often differ.

User avatar
bobcat2
Posts: 5202
Joined: Tue Feb 20, 2007 3:27 pm
Location: just barely Outside the Beltway

Re: Need, ability and willingness to take risk

Post by bobcat2 » Tue Jan 07, 2014 3:34 pm

Different investments have different risks, but they all have risk of one or more types. I think that is true on pretty much any financial planet. :-)
The degree of risk can be quite different. I have two health risks. I have a risk of developing pancreatic cancer and a risk of developing a hangnail that I may tear. On your planet these health risks are similar no doubt. :D

BobK
In finance risk is defined as uncertainty that is consequential (nontrivial). | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.

Rodc
Posts: 13601
Joined: Tue Jun 26, 2007 9:46 am

Re: Need, ability and willingness to take risk

Post by Rodc » Tue Jan 07, 2014 7:53 pm

Hi Paul,

Sounds like we are in pretty much the same place. FWIW: when the "you" slipped into my post I really meant things like "when one ...)

I may read too much into Larry's version of need (and some others including at times Rick and wbern when they suggest to invest wisely you have to start with predictions and estimates of what each asset class will return to target a given return, you need to be good at higher level math, etc.) which is really what I object to, not yours.

Rod

ADDED: Perhaps I should be careful not to to presume too much as far as what Larry really means. Larry, if you read this thread can you confirm or clarify? I think what you mean is something like an investor decides he can save $X per month, he decides when he wants to retire, he decides how much he needs saved (or how much income he needs and then uses the 4% rule or something to get his needed total). Then he whips out his handy dandy calculator and figures out that to hit that total in that many years saving that much each month he needs a CAGR of 5.4% (or whatever). That 5.4% is his "needed return", and from that and estimates of return and risk for each asset class he figures out an allocation and then assesses the associated risk. If that risk is within his ability and willingness he is good to go. If not something has to give. Is that about right?
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

pkcrafter
Posts: 12830
Joined: Sun Mar 04, 2007 12:19 pm
Location: CA
Contact:

Re: Need, ability and willingness to take risk

Post by pkcrafter » Tue Jan 07, 2014 11:47 pm

bobcat2 wrote:
basically nothing is going to work if risk tolerance is breached. Moving out of stocks can be very damaging. It converts temporary loss to permanent loss--shallow risk to deep risk.
Not moving out of stocks can also be very damaging. Don't take my word for it, ask any Japanese investor who stayed heavily invested in the Japanese stock market from 1990-2008. The real cumulative equity loss was about 70%. Over that same period Japanese bonds roughly doubled in real value. Staying in stocks destroyed portfolios. There is nothing wrong with deciding that your prior strategy of holding a large equity position was a poor decision, admitting your mistake, and lowering your equity position to a more prudent lower level.

Bob, I agree that the market can do irreparable damage. One way is by selling out in a crash and another is holding during a crash that does not rebound. And the second reason is why I never advocate 100% stocks. You note that Japanese bonds doubled and this is the reason for major asset class diversification. As for selling, there is nothing wrong with deciding your strategy is too aggressive and lowering it, but this is best done before the crisis arises. I admit investors do miscalculate, but those who realize they aren't cut out for high risk and adjust before they are truly tested are better off. Anyway, I think our difference of opinion revolves around whether willingness is more important than capacity. If that's all there is, I think we aren't completely in different boats, just different seats. :happy

JM Keynes:
“When I’m wrong, I change my mind. What do you do?”


Pretty much what you do, I think. :happy

Link - http://quoteinvestigator.com/2011/07/22 ... ange-mind/

BobK
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

pkcrafter
Posts: 12830
Joined: Sun Mar 04, 2007 12:19 pm
Location: CA
Contact:

Re: Need, ability and willingness to take risk

Post by pkcrafter » Wed Jan 08, 2014 12:11 am

Rodc, yes we are in agreement, and I have some discomfort with need as well. I don't have a problem saying young investors have a need to take risk because it simply means they have a better chance at accumulating a reasonable amount of money to retire on than if they simply use cash or bonds. Of course, reasonable goals, savings rates, and behavioral aspects play a big roll as well. I do have some concern about anyone saying I need an 8% return and I have to take the risk to get it.

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

oslocal
Posts: 63
Joined: Sat May 21, 2016 5:30 pm

Re: Need, ability and willingness to take risk

Post by oslocal » Fri Jan 12, 2018 12:08 am

Stumbled upon this thread and thought it was very insightful reading. (If anyone disagree, sorry to revive)

I feel that one aspect that was discussed a lot was the need for young people (e.g. 30 year olds) to take risk due to $0 to their name, debts, etc., and uncertain future.

What, if any, would change if the numbers are more like $400K invested, $250K per year income, living below means, but no great willingness to take risks.

How to quantify the need?

User avatar
willthrill81
Posts: 4632
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: Need, ability and willingness to take risk

Post by willthrill81 » Fri Jan 12, 2018 12:16 am

oslocal wrote:
Fri Jan 12, 2018 12:08 am
Stumbled upon this thread and thought it was very insightful reading. (If anyone disagree, sorry to revive)

I feel that one aspect that was discussed a lot was the need for young people (e.g. 30 year olds) to take risk due to $0 to their name, debts, etc., and uncertain future.

What, if any, would change if the numbers are more like $400K invested, $250K per year income, living below means, but no great willingness to take risks.

How to quantify the need?
It can be difficult to accurately quantify need because it depends on so many factors, many of which are subjective (e.g. personality) and others of which are unknown (e.g. how risky will an investment be going forward, what will the returns be). I'd say that one should start with one's personal goals, when one wants to achieve those goals, and work backward from there. For instance, if I want to be financially independent at age 55, how big of a portfolio do I think I'll need to achieve that? How much time do I have? What's my risk tolerance (can be tough to pin down, and it seems to be a moving target for most)? These can help you determine your need.

Some believe that risk tolerance is rather fixed, mostly determined by one's personality and prior experiences. I think that both of these factors and others certainly impact risk tolerance, but I think that education and a good dose of reality can help dramatically. For instance, one might say "I don't ever want to see my portfolio drop by more than 10%." But with such a low risk tolerance, it may be impossible for this person to ever reach their financial goals. So should they just throw their hands up in the air? Of course not. They need to learn that drawdowns are a common feature of most asset classes, especially those with returns that are likely to beat inflation significantly over time.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

dbr
Posts: 27207
Joined: Sun Mar 04, 2007 9:50 am

Re: Need, ability and willingness to take risk

Post by dbr » Fri Jan 12, 2018 9:13 am

willthrill81 wrote:
Fri Jan 12, 2018 12:16 am

Some believe that risk tolerance is rather fixed, mostly determined by one's personality and prior experiences. I think that both of these factors and others certainly impact risk tolerance, but I think that education and a good dose of reality can help dramatically. For instance, one might say "I don't ever want to see my portfolio drop by more than 10%." But with such a low risk tolerance, it may be impossible for this person to ever reach their financial goals. So should they just throw their hands up in the air? Of course not. They need to learn that drawdowns are a common feature of most asset classes, especially those with returns that are likely to beat inflation significantly over time.
Well said and gets at the essence of what gets all too confused in these discussions.

garlandwhizzer
Posts: 1882
Joined: Fri Aug 06, 2010 3:42 pm

Re: Need, ability and willingness to take risk

Post by garlandwhizzer » Fri Jan 12, 2018 1:10 pm

willthrill81 wrote:
Some believe that risk tolerance is rather fixed, mostly determined by one's personality and prior experiences. I think that both of these factors and others certainly impact risk tolerance, but I think that education and a good dose of reality can help dramatically. For instance, one might say "I don't ever want to see my portfolio drop by more than 10%." But with such a low risk tolerance, it may be impossible for this person to ever reach their financial goals. So should they just throw their hands up in the air? Of course not. They need to learn that drawdowns are a common feature of most asset classes, especially those with returns that are likely to beat inflation significantly over time.
1+

Well said.

Garland Whizzer

Post Reply