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?"

Risk tolerance defined
Risk tolerance is defined by author Rick Ferri as:

Bogleheads author William 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

Risk can only be managed by diversifying your portfolio. This means distributing your investments across the major investment categories known as asset classes, which are  stocks,  bonds, and cash or  cash equivalents.

You set your level of risk, the tolerance you have to a decline in your portfolio's value, by adjusting your asset allocation.

Why is risk tolerance important?
Risk tolerance is a key factor in creating an asset allocation (the percentage of stocks, bonds, and cash) that will allow investors to stay the course during the inevitable market downturns.

Author Larry Swedroe defines asset allocation as "the process of investing assets in a manner reflecting one’s unique ability, willingness and need to take risk," with willingness referring to risk tolerance and whether investors have the “fortitude and discipline” to stay with an allocation during market downturns.

Ability to take risk involves the investment time horizon, need for liquidity, stability of earned income, and the flexibility to adapt if there is a need for a 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 (sleep 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 determined by the rate of return required to achieve financial objectives. If the goal requires a higher return, the investor needs to take more risk with the expectation that doing so will result in a higher return. Perhaps more importantly, once the 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.

Why is risk tolerance difficult to determine?
Knowing your emotional tolerance for investment risk means knowing yourself and your unique goals and needs - and it is not easy.

Jason Zweig writes in his book on neuroscience, Your Money & Your Brain, that "... perception of investment risk is in constant flux, depending on your memories of past experiences, whether you are alone or part of a group, how familiar and controllable the risk feels to you, how it is described, and what mood you happen to be in at the moment.”

Investors are often asked by financial advisors to take risk tolerance questionnaires intended to help determine how aggressive or conservative their investments should be. But Jane Bryant Quinn in her book, How to Make Your Money Last, calls the questionnaires "... generally bunk. You’ll lean toward more risk if stocks are going up, you’ve had a good day at the office and your shoes don’t pinch. If you’ve had a bad day because stocks went down and your unemployed child is moving in, you’ll suddenly feel more conservative."

Ferri says some questionnaires that are worded well may be helpful, but "...overall they are not the answer to the asset allocation question. ... Finding a person’s maximum tolerance for risk takes a lot more than a questionnaire. It requires soul-searching. We tend to be brave in a bull market, and this means that it is not the ideal time to search for our risk tolerance. Soul-searching should be done in a bear market when we are not sure what is going to happen next."

Self-assessment questionnaires
Various advisory services offer self-assessment questionnaires to help determine your risk tolerance. Vanguard, for example, has a Get A Recommendation tool that is typical of the genre; it asks six questions and suggests a portfolio resembling one of the LifeStrategy funds.

These tools are useful with caveats. Their real purpose may be to protect the firm by putting the client on record as accepting a certain level of risk.

The usefulness of the questionnaire has recently come into question, as it does not address three factors that have the greatest impact on a person’s attitude toward risk:
 * 1) One’s hereditary penchant to take on financial risks;
 * 2) One’s friends and acquaintances and their influence on framing opinions;
 * 3) One’s life experiences, especially in the formative years.

However, this kind of tool is a worthwhile exercise because it at least asks a question that is different from saying "What percentage of stocks do you think you are comfortable with?"

Behavioral pitfalls
Understanding and avoiding behavioral pitfalls will ultimately have a greater impact on investing success than any other factor. Since emotions and subsequent behavioral pitfalls are frequently associated with miscalculating risk tolerance and asset allocation, the new investor should be aware of behavioral pitfalls before making asset allocation decisions.

An important pitfall to be aware of is loss aversion, the emotional tendency to strongly prefer avoiding losses over acquiring gains. As an example, loss aversion implies that one who loses $100 will feel twice the emotional pain as another person will feel satisfaction from receiving $100. Common indications include checking your portfolio on an almost daily basis, selling funds before you intended to lock in profits, or selling when you didn't intend to in order to avoid further losses.