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:
...a measure of the amount of price volatility and investment loss you can withstand before changing your behavior. ... An emotional decision to change or abandon an investment plan as a result of market risk ultimately increases portfolio risk and reduces return. If an investor has been in a bad market long enough to lose money, that investor doesn’t want to be out of the market when it turns around. That becomes a strategy of all risk and no return.
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
You can adjust the level of risk in your portfolio by adjusting your asset allocation.
Why is risk tolerance important?
|Nothing is more important for investors than learning how much they can stand to lose. But nothing is harder to learn - before it’s too late.|
|-- Jason Zweig (WSJ blog)|
Risk tolerance is a key factor in creating an asset allocation (the percentage of stocks, bonds, and cash or cash equivalents).[note 1] 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.[note 2]
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 determined by the rate of return required to achieve financial objectives. Any investor deciding to take more risk because of perceived "need" should do so keeping in mind that taking extra risk could well backfire and lead to lower returns. 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."
Various advisory services offer self-assessment questionnaires to help determine your risk tolerance and define an initial asset allocation.
Vanguard, for example, offers the following tools:
- An Investor Questionnaire. By answering a few questions, you can quickly determine an asset allocation. This tool does not recommend any funds.
- The second Vanguard offering is the Get A Recommendation tool and is typical of the genre; it asks six questions and suggests a funds portfolio resembling one of the LifeStrategy funds.
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:
- One’s hereditary penchant to take on financial risks;
- One’s friends and acquaintances and their influence on framing opinions;
- 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?"
|When it’s time to make investing decisions, check your emotions at the door.|
|-- Bogleheads' Guide To Investing|
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.
- Fixed income is sometimes considered to be a combination of bonds and cash. See Fixed income.
- From: Asset allocation:
Ability relates to an investor's ability to withstand the ups and downs of the market without getting nervous and making changes to the asset allocation. Selling in the face of a decline is about the worst thing an investor can do. Here is a table offered by author Larry Swedroe, based on the 1970s bear market, showing the amount of decline for various stock/bond allocations:
Asset Allocation %
20/80 5% 30/70 10% 40/60 15% 50/50 20% 60/40 25% 70/30 30% 80/20 35% 90/10 40% 100/0 50%
For example, an investor would be willing to accept a loss of 35% in the portfolio if she held an allocation of (80% stocks / 20% bonds). This table is from the 1970's; performance during other time periods will have different results. The general idea is for investors to select an asset allocation they are comfortable with. Source: Investment Planning, forum discussion.
- Determining a client risk tolerance in advance of making investment recommendations is often required by regulators.
- Bogleheads' Guide To Investing 2nd ed.
- All About Asset Allocation, 2nd ed.
- William Bernstein (2010), The Investor's Manifesto. John Wiley & Sons, Inc. ISBN 978-0470505144. pp.75-80
- Swedroe, Larry, Asset Allocation Guide: How much risk should you take?, CBS Moneywatch, February 3, 2014.
- Swedroe, Larry, Asset Allocation Guide: What is your risk tolerance?, CBS Moneywatch, February 12, 2014.
- Swedroe, Larry, Asset Allocation Guide: How much risk do you need?, CBS Moneywatch, February 19, 2014.
- Jason Zweig (2007). Your Money & Your Brain. New York: Simon & Schuster. p. 128. ISBN 978-0743276689.
- Jane Bryant Quinn (2016). How to Make Your Money Last: The Indispensable Retirement Guide. New York: Simon & Schuster. p. 230. ISBN 978-1476743769.
- Beyond the Questionnaire: New Tools for Risk Profiling, CFA Institute Annual Conference (Montreal), April 27, 2015, viewed April 25, 2016.