Assessing risk tolerance

Assessing risk tolerance is a critical step in determining the appropriate trade off between the risk and expected return of a portfolio. Selecting a mix of risky and risk-free assets (or higher-risk and lower-risk assets) is one of the most important decisions in designing a portfolio. Investors must develop a rational assessment of risk tolerance to make rational decisions about portfolio design.

Most approaches to assessing risk tolerance consider these criteria in one way or another:
 * Attitude toward risk
 * Investment time horizon
 * Other factors that affect ability to compensate for investment losses, for example, net worth, stability of income, future liabilities, and flexibility of goals.

This article presents several frameworks to help you to assess your risk tolerance. It uses the term risk tolerance to describe both an investor's capacity to bear risk and their attitude toward risk. However, some authors use the term risk tolerance to describe only an investor's attitude toward risk; that is, the psychological and emotional aspects related to taking risk. To avoid confusion, the article uses "determining appropriate risk exposure" instead of "assessing risk tolerance" for frameworks that use the term risk tolerance to refer only to an investor's attitude toward risk.

Risk tolerance
Risk is the uncertainty (variation) of an investment's return, which does not distinguish between a loss or a gain. However, investors usually think of risk as the possibility that their investments could lose money.

Risk tolerance is an investor’s emotional and psychological ability to endure investment losses during large market declines without selling or undue worry, such as losing sleep.

To know whether a portfolio is right for your risk tolerance, you need to be brutally honest with yourself as you try to answer the question, "Will I sell during the next bear market?"

Knowing your emotional tolerance for investment risk means knowing yourself and your unique goals and needs - and it is not easy. The next sections show different ways you can assess your risk tolerance.

Boglehead's Guide To Investing
The Bogleheads' Guide To Investing discusses determining appropriate risk exposure in the chapter on asset allocation. The context is designing an efficient portfolio and "staying the course".

The book explores four areas:
 * Goals
 * Time frame
 * Risk tolerance
 * Personal financial situation

Examples of goals are saving for a home, a child's education, or retirement.

Stocks are suitable for long time frames, whereas medium and short-time frames require less risky investments.

Risk tolerance is about the psychological and emotional ability to stick with the investment plan during large market declines. Whether or not you think you could sleep well at night (the sleep test) with your current asset allocation (proportions of stocks, bonds and cash) is one indicator of risk tolerance.

Your own personal financial situation affects how much risk and what types of risk are appropriate. Stability of income and net worth affect the need to take risk. Investors with higher guaranteed retirement incomes (for example, a pension or social security) or high net worth do not need to take as much risk; that is, they have a lower requirement to invest in stocks.

The book refers to three tools, along with an investor's own experience, to help factor risk into your asset allocation:
 * John Bogle, founder of Vanguard, suggests that a rough "rule of thumb" to hold your age in bonds.
 * Consider the maximum decline to expect with various stock/bond ratios. The original version of the book presents maximum declines in the 2000 to 2002 bear market, but the maximum declines in the 2008/2009 bear market were worse; a common rule of thumb is to be prepared for a 50% loss in the stock portion of your portfolio.
 * Vanguard provides an online questionnaire and suggested asset allocations. The book includes a version of the questionnaire as an Appendix, but see the Vanguard website for the latest version.

The book presents various sample portfolios based on these "stages in life":
 * Young investor
 * Middle-aged investor
 * Investor in early retirement
 * Investor in late retirement

Larry Swedroe: ability, willingness, and need to take risk
Bogleheads author Larry Swedroe suggests that investors evaluate their risk tolerance by considering their ability, willingness and need to take risk.

Ability to take risk involves investment time horizon, liquidity needs, stability of earned income, and the flexibility to adapt if the portfolio does not achieve its expected returns (that is, "plan B").

Willingness to take risk is characterized as the eat well/sleep well trade-off. Taking more risk is required to enable the possibility of higher expected returns (eat well). However, if investors take more risk than they are emotionally able to handle, then it is likely that they will abandon their investment plans if their portfolios suffer sufficiently severe losses. So it is unwise for investors to take so much risk that they will be unable to sleep well during the inevitable stock market downturns.

Need to take risk is related to the investment goal. If the goal requires a higher expected return, an investor needs to take more risk with the expectation that doing so will result in a higher return. Perhaps more importantly, once an investor has "won the game" by accumulating sufficient wealth, it is unwise to take more risk than is needed, since the value of additional gains is much less important than the consequences of severe losses.

William Bernstein
Bogleheads author William Bernstein discusses determining appropriate risk exposure in the context of deciding on your allocation between stocks and bonds based on age and risk tolerance (attitude toward risk), at least as a starting point.

A very young investor has many years to take advantage of the inevitable bear markets by buying stocks at depressed prices. At the other extreme, a retired person typically is spending down savings, and therefore an extended bear market is more likely to endanger the likelihood that a stock-heavy investment portfolio will last through retirement.

In finance terms, younger investors have more human capital; that is, their total future earnings are much larger than their investment portfolio. By contrast, a retired investor who is not working has no human capital. Human capital can be considered as a bond-like investment, so the high value of a young investor's human capital can justify a higher allocation to stocks.

Middle-aged investors fall somewhere in the middle, so perhaps might consider dividing their portfolio evenly between stocks and bonds.

Other than age, risk tolerance is the other major consideration in determining asset allocation. Bernstein uses risk tolerance in the sense of attitude toward risk. Bernstein suggests that investors can evaluate their risk tolerance based on how they reacted to the financial crisis during 2008 and early 2009:


 * Sold: low risk tolerance
 * Held steady: moderate risk tolerance
 * Bought more: high risk tolerance
 * Bought more and hoped for further declines: very high risk tolerance

Bernstein mentions age in bonds as the most common age-based rule of thumb, and suggests that investors might modify this based on risk tolerance as follows (stated in terms of percentage point increase or decrease to the stock allocation):


 * Very High: +20%
 * High: +10%
 * Moderate: 0%
 * Low: -10%
 * Very Low: -20%

For example, a 50-year-old with moderate risk tolerance might hold a 50/50 stock/bond allocation (age in bonds), while a 50-year-old with very high risk tolerance might hold a 70/30 stock/bond portfolio.

Bernstein emphasizes that this is just a starting point. A very wealthy, frugal retiree might have a higher stock allocation since the chance of running out of money is low, and the investment time horizon is relatively long considering the lifetimes of their heirs and other beneficiaries. At the other end of the spectrum, a retiree whose annual living expenses consume a relatively large percentage of retirement savings might consider reducing spending and use most retirement savings to purchase a fixed annuity.

Bernstein points out that investors who have not lived through serious market declines tend to overestimate their risk tolerance. He strongly urges that investors invest conservatively until they have experienced their first bear market. This gives them the chance to determine how they will behave as they see the value of the stock portion of their portfolio decline significantly; for example, will they have the discipline to rebalance from bonds to stocks when it seems most frightening to do so?

Bernstein presents a criterion he describes as the "equipoise point" to help with the stock/bond allocation decision. This is the point at which the pleasure of seeing the stock portion of your portfolio increase in value during a bull market just offsets the regret of not having a higher allocation to stocks. It also is the point at which the pain of stock losses during a bear market counterbalances the positive feelings provided by your bonds (which can be rebalanced into stocks at lower prices).

Rick Ferri: lifecycle model
Bogleheads author Rick Ferri suggests using a modified version of the age in bonds rule of thumb to help decide on the split between higher-risk and lower-risk assets, and presents asset allocation decisions in terms of a life-cycle investing framework.

Age is an important factor in determining asset allocation. Older investors have less time to make up losses, and if still working, have fewer years to replace those losses from savings. However, applying the simple age in bonds rule of thumb is more appropriate for younger investors than for older investors.

The financial situations of younger investors are less diverse, so holding your age in bonds probably is a reasonable guideline. Financial assets are small relative to future earnings, so large stock market fluctuations will have relatively small impact on long-term wealth. A 70/30 stock/bond allocation probably is fine for most 30-year-olds.

However, there is much more diversity in the financial situations of older investors; for example, accumulated wealth, access to pension plans, family size, and so on. Although you can use age in bonds as a starting point, it is much more likely that you will need to make significant adjustments based on your personal financial situation. The concept of "asset allocation age" aims to account for these factors.

For example, investors whose wealth is large relative to spending needs can afford to take more risk, and therefore have asset allocation ages that may be higher than their chronological ages. Examples of factors to consider in determining asset allocation age are income needs, retirement needs, pensions, living expenses, bequeathing goals, passive income sources, attitude toward risk, debt, and possible inheritances.

You can also use a life-cycle investing model to help decide on how to allocate portfolio assets between higher-risk stocks and lower-risk fixed-income investments. There are four life phases to consider:


 * Early savers, typically ages 20 to 39, with an appropriate allocation to stocks in the range of 60% to 80%.
 * Midlife accumulators, typically ages 40 to 59, with an appropriate allocation to stocks in the range of 50% to 70%.
 * Transitional retirees, typically ages 60 to 79, with an appropriate allocation to stocks in the range of 30% to 70%.
 * Mature retirees, typically age 80 and up, with an appropriate allocation to stocks in the range of 20% to 60%.

Developing a good understanding of how you are likely to react to market volatility and bear markets is also critical in determining an appropriate asset allocation. Risk tolerance is defined as "a measure of the amount of price volatility and investment loss you can withstand before changing your behavior."

Although risk tolerance questionnaires can be useful as a starting point in discovering your risk tolerance, they generally are not sufficient. An asset allocation stress test is another useful tool. This involves working through a bear market scenario, month by month, using a target portfolio with real dollar amounts, and determining if you are likely to stick with a rebalancing plan as the value of the portfolio declines.

Daniel Solin
Daniel Solin is the author of The Smartest Investment Book You'll Ever Read, listed in the Bogleheads Book recommendations and reviews, and the subject of this Taylor's Gem.

Chapter 29 in another one of Solin's books, The Smartest Money Book You'll Ever Read, is titled Assessing Your Risk Capacity. Solin presents five major factors for assessing risk capacity:


 * Time horizon and liquidity needs. Longer time horizon and lower shorter-term liquidity needs increase risk capacity.
 * Income and savings rate. Higher income and savings rate increase risk capacity.
 * Net worth. Higher net worth increases risk capacity.
 * Attitude toward risk. This is what most people refer to as risk tolerance, and is the emotional component of handling losses.
 * Investment knowledge. The better your understanding of portfolio theory and the risk-return trade off, the higher your risk capacity.

Solin provides a Risk Capacity Survey on his website. There is a quick survey with five questions, a 25-question "complete" survey, and a 19-question survey for 401(k) plans.

CFA Institute
CFA Institute (Bodie, Kane, Marcus, 2008, chapter 21): Investors and Objectives, Investor constraints (Liquidity, Investment Horizon, Regulations, Tax Considerations, Unique Needs.