Only when the tide goes out do you discover who’s been swimming naked.” – Warren Buffett
It has been almost a month since my last post. It has been more than two months since I wrote an introduction post to my planned investing series. My plan was to begin publishing weekly posts within the investing series beginning in October. Then life happened. Or better yet, life in 2020 continued to happen. Like many, life has been challenging in 2020. Mrs. Henry and I have been very fortunate compared to others who have lost loved ones or lost their job in 2020. However, in relation to prior years, it has definitely been a challenging year for the Henry household and it hasn’t gotten any easier in the last two months. Mrs. Henry and I were reflecting on the month of November last night. Neither of us remember where it went. Work hours are long and any free time that we may have is typically eaten up by our two children and completing the activities necessary to keep life on track. Again, we have a lot to be thankful for, but I am just trying to provide some context to my erratic posting.
Today’s Topic: Understanding Risk
“Risk comes from not knowing what you’re doing.” – Warren Buffett
I had a framework that would have allowed me to be about 6 – 8 posts into my investing series as we began to transition into year-end. This would have allowed me to lay the groundwork for those less familiar with the types of investment accounts, investment vehicles, stocks vs. bonds, etc. I still plan to cover all of these topics in detail. However, since the last two months got away from me, I want to focus on areas that I think are potentially important right now. Financial markets are once again at an all time high. In addition, this is the time of the year that many, including myself, establish their financial goals for the upcoming year. As a HENRY, you likely already invest to some degree even if it is only in retirement vehicles. It is important to understand what you are investing in and your subsequent level of risk. It is quite possible you are taking too much risk and don’t know it. It is also possible you are not taking enough risk. Both can be dangerous to you ability to build wealth and achieve FI. For this reason, I thought the most important place to start is risk.
What is Risk Tolerance?
Risk tolerance as defined by Investopedia as the amount of risk that an investor is comfortable taking, or the degree of uncertainty that an investor is able to handle. [1] In layman’s terms, I define risk tolerance as simply how much risk you are willing to take with your money. Simplified further, how much money can you stomach to lose.
Understanding your risk tolerance is a very important part of investing, especially long term investing. It is unfortunate that many find out their true risk tolerance in a down market, and end up making decisions that have a detrimental impact to their ability to build long-term wealth. Let’s look at a few important aspects to risk tolerance that may be somewhat obvious, but are important to highlight nonetheless.
- Risk tolerance encompasses both risk and reward. Every investment has some level of risk. Typically, the greater the risk, the greater the reward. The key to successful investing is understanding the risk vs. reward of your investment decisions and making decisions that align with your personal risk tolerance.
- Risk tolerance changes over time. It is not static. Typically, the younger you are the more risk you are willing to take in an effort to grow your wealth. You have a lengthy investment timeline in front of you. As you grow older, you typically are willing to take on less risk as you seek to preserve the assets you have built up over your investing lifetime.
- For those seeking to achieve FI or FIRE earlier in life, your risk tolerance may not conform to the traditional timeline. As noted above, your risk tolerance typically declines as you grow older. This isn’t a function of your age necessarily. This is a function of your assets and your desired retirement timeline. If you are seeking to achieve FI or FIRE earlier, then your risk tolerance will likely decline earlier than someone seeking to achieve FI at traditional retirement age.
- Risk tolerance will drive which asset classes you invest in and to what degree relative to your overall portfolio. Each asset class (i.e. stock, bond, etc.) has a corresponding risk. Stocks/equities are typically riskier than bonds. Bonds are riskier than cash. I will get into much more detail on the types of assets classes in another post for those with less knowledge in this area. The key here is understanding that what you are invested in is very important. What you are invested in has a risk and what you are invested in has a subsequent reward.
- Risk tolerance has an emotional/psychological component that has nothing to do with numbers or timelines or goals. Money is often a source of anxiety for many. The anxiety of losing money is even worse. It is important to understand and acknowledge the emotional component. It is equally as important to be as educated as possible because investing based upon emotion can have detrimental impacts to your ability to build wealth long-term.
Assessing and understanding your risk tolerance is essential for any successful long-term investor. Having too high of a risk tolerance and thus taking too much risk can result in a loss that make take years or decades to recover from. Perhaps, you may never recover. Conversely, having too low of a risk tolerance can add years or decades to your FI timeline or working career because it will drive investment decisions that do not give you an opportunity to truly leverage the miracle of compound interest.
What is Risk Capacity?
Risk capacity as defined by Investopedia is the amount of risk that an investor “must” take in order to reach their financial goals. [1] In layman’s terms, I define risk capacity as simply how much risk you can take and should take. Simplified further, how much money can you afford to lose. Understanding your risk capacity if just as important if not more important than understanding your risk tolerance. Let’s again look at a few important aspects of risk capacity.
- Risk capacity can be partially driven by your income. The greater your income, the greater ability you have to take risk since your income allows you to recover faster. As a HENRY, your above average income can afford you to opportunity to take more risk than someone with a lower income.
- Risk capacity can be partially driven by your net worth or assets. The greater your net worth, the greater ability you have to take risk since your funds/assets are not as limited as someone with a lower net worth. As a HENRY, your above average income once again allows you to build your net worth faster.
- Risk capacity also changes over time. Someone that is younger has much more risk capacity than someone that is older. As discussed previously, compound interest requires time. As you age, you have less time. Less time equates to less growth, and a lessened ability to grow your assets results in a greater need to preserve them.
- For those seeking to achieve FI or FIRE earlier in life, your risk capacity once again may not conform to the traditional timeline. For someone that is 55 years of age planning to retire at 65 years of age, only 10 years remain before you begin to spend your accumulated assets (i.e. retire and spend the money you have saved and invested). For someone that is 30 years of age seeking FI or FIRE at 40 years of age, the timeline is the same even though you are 25 years earlier from an age perspective. Age is important but your goals and timeline are as well when it comes to your risk capacity.
Risk capacity has less of an emotional or psychological side to it than risk tolerance. Risk capacity is primarily driven by the math. With risk capacity, considerations primarily center upon timeframe, income requirements, rate of return, etc. Assessing and understanding your risk capacity is also essential for any successful long term investor. Having a low risk tolerance and high risk capacity can have a serious impact on your ability to build wealth while having a high risk tolerance with a low risk capacity can have a serious impact on your ability to preserve your wealth.
What Does This Mean?
In order to better understand risk from an investing perspective, it is important to understand risk vs. reward as it relates to basic portfolio composition. Fortunately, there is plenty of data to draw from to better understand how your portfolio can impact your potential returns as well as your potential losses. One of the world’s largest investing companies, Vanguard, has an excellent resource for portfolio allocation models on their platform. Vanguard breaks the models into three separate categories.
Income-Oriented Investor:
An income-oriented investor seeks capital preservation with modest long-term growth. Income generating investments (i.e. bonds, cash, and other income generating assets) would be a larger part of an income-oriented investor’s portfolio. Typically the investing timeline for an income-oriented investor would be short to mid-range. Think low risk tolerance and/or low risk capacity. The visuals below were pulled from Vanguard’s website here.
Balanced-Oriented Investor:
A balanced-oriented investor seeks more growth than in income-oriented investor and is willing to tolerate short-term fluctuations in exchange for greater capital growth. However, unlike a growth-oriented investor, maximum growth is not the intent as potentially large fluctuations are not desired. As the name implies, a balanced-oriented investor’s portfolio would be balanced between income generating investments and equities/stocks. Typically the investing timeline for a balance-oriented investor would be mid-range to long-range. Think moderate risk tolerance and/or moderate risk capacity. This could also be someone who has the capacity to take great risk, but their risk tolerance is low or they do not need to take the risk to achieve their goals (i.e. someone nearing or reaching FI earlier in life). This is typically the profile of someone seeking to preserve assets while still taking advantage of growth.
Growth-Oriented Investor:
A growth-oriented investor seeks to maximize long-term growth and is thus willing to accept potentially large short-term fluctuations. Typically the investing timeline for a growth-oriented investor would be long-term. Think high risk tolerance and/or high risk capacity. This is typically the profile of someone that is seeking to accumulate assets.
There is one thing the portfolio models above lack. The years with a loss are noted. What is not noted is the timeline to recover in the event of a loss. In doing a quick Google search, based on a research study from Bank of America Securities [2], it has taken ~ 1,100 trading days on average to regain what was lost during a bear market. That is approximately 4 years or so. Of course, past performance does not predict future performance, but it at least gives you some context. Armed with this knowledge, I think the Vanguard Portfolio Allocation Models are a great way to understand the risk vs. reward of investing. Could you stomach a 25%, 30%, 35% or 40%+ loss of your portfolio in exchange for a greater rate of return long-term? If you experience a market decline of this nature and watched months or years of savings evaporate, would you stay the course without selling? Your answers to questions like this allow you to assess your risk tolerance.
Now consider your risk capacity. Can/should you take a potential 25%, 30%, 35% or 40%+ loss in your portfolio in exchange for the potential greater return? Do you have time for your portfolio to recover if this occurs? Do you need that rate of return to achieve your goals? If not, then perhaps you should not take the risk even if you can take the risk. If you are close to achieving FI or you have already achieved FI, you may not need to take the risk. Once again, investing and personal finance is personal. Selecting a portfolio allocation is no different.
Examining the portfolio allocation models above doesn’t provide you with your risk tolerance or risk capacity. It simply provides insight into how your portfolio’s structure and the balance between income generating assets and growth assets can impact your investment portfolio over time. This topic gets much more complicated when you begin to consider sequence of return risk, correlated and non-correlated assets, diversification, etc. The point of today’s post is to gain a basic understanding of risk. Hopefully, you have a good grasp of your risk profile and the financial risk you are taking.
How Do I Determine My Risk Tolerance/Capacity?
Determining your risk tolerance can sometimes be difficult since emotion is involved. People often overestimate their risk tolerance only to realize in a bear market that they cannot stomach the fluctuations associated with their portfolio allocation. When the COVID pandemic hit earlier this year, many got a gut check of their risk tolerance as the market tanked during a short period of time. Unfortunately, it often takes a bear market or a black swan event like COVID-19 to truly assess your risk tolerance. Determining your risk capacity does not have an emotional element, but it can be equally as complicated, especially if you do not like getting into the numbers. There is a lot to consider when determining your risk tolerance and capacity. Here are few questions I ask myself to assess my own risk tolerance and capacity.
- I ask myself how much risk do I want to take? What is my perceived risk tolerance? How risk-adverse am I in life in general? How about in my financial life?
- I review historical data including the Vanguard Portfolio Allocation Models noted above and consider the risk vs. reward with my current net worth, timeline, and goals.
- I ask myself how much risk can I take? Considerations include my age, investing timeline, goals, income, assets, and needed rate of return. At the heart of this analysis is understanding (1) the loss I can withstand and still recover and achieve my goals/target and (2) the investment mix needed to achieve the needed rate of return necessary to achieve my goals without taking on unnecessary risk.
- I ask myself how much risk should I take? This question could arguably be the same as (3). However, I think it is a separate question, especially for those pursuing FI. You will often hear the phrase “winning the game” in the FI world. This phrase characterizes investing and saving for FI as a game where the goal you are seeking to achieve is FI or the ability to sustain your lifestyle in perpetuity from your investments alone. Once you have “won the game” it likely is no longer necessary that you take as much risk even if your risk tolerance is high and you’re still young. Why take on unnecessary risk if it is not required? This is something to consider which is why I think this question should be considered separately.
Putting It All Together
I chose to write this particular post this week for several reasons.
First, we are preparing to transition into 2021. December/January is the time period that I ensure I have a financial plan for the new year. I set goals in relation to my finances which include my desired savings rate and expected contributions to each account (i.e. retirement, liquid savings, taxable account, etc.). This is also the time period where I try to objectively re-assess my risk. Then I can make changes as necessary to ensure my investment portfolio matches my desired risk profile, to include my risk tolerance AND my risk capacity. A lot of people do the same type of thing around this time period. If you currently do not, I highly recommend you do.
Second, in case you haven’t taken notice or don’t follow the market as closely, the market is once again at an all time high. The market has essentially recovered all of the losses experienced in 2020 due to the Pandemic and the corresponding economic shutdowns. Eventually, there will be a prolonged bear market. Of course, I do not know the future. No one knows the future. Markets could continue to go up next year for all I know. However, I can virtually guarantee you one thing. At some point, we will experience a prolonged bear market. Like most things, the market moves in cycles. There are prolonged periods of growth (bull markets) and there are prolonged periods of decline (bear markets). When a bear market does occur, you want to make sure that your investment portfolio aligns with your risk profile. In my opinion, 10 – 11 years into the current bull market is as good of a time as any to determine what changes need to be made.
Conclusion:
Hopefully, reading this post will help you better assess and understand your personal risk profile. With a little research, you can then also determine your current level of risk, and you can make changes as necessary. I plan to get into further detail in future posts. This article was only meant to introduce the topic of risk and make sure it is something you are considering. If you manage your own investments, I encourage you to take action to better understand your current level of risk. If you pay someone to manage your investments, you should stop! No, no, just kidding… sort of. We will get into that in much more detail later. If you pay someone to mange your investments, that is absolutely fine. However, I encourage you to ensure you are in alignment with how they are investing your money and that you are OK with the risk they are taking. Regardless of your situation, you should understand you current level of risk as it relates to your risk tolerance and risk capacity. After all, you don’t want to be caught naked when the tide goes out… Unless of course swimming naked is your thing… If that’s the case, have at it.
Regards,
Henry
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Henry’s Take:
I currently have a portfolio allocation of 80/20. 80% of my portfolio is a diversified mix of stock index funds. The remaining 20% is invested in bonds and other low risk investments including cash. I believe that I have a high to moderate risk tolerance. My risk capacity is where I spend most of my mental bandwidth. If you recall from the Vanguard Portfolio Allocation Models, an 80%/20% stock/bond portfolio had an average annual return of 9.4% between 1926 and 2018. The largest single year loss was ~ 35%. 24 of 93 years or ~ 25% of the years during this time period resulted in a loss. As someone in the pursuit of FI earlier in life, my risk capacity is evolving quickly as my assets continue to grow and I progress along my FI timeline. As a result, I am continually re-evaluating my current risk in relation to what risk I need to take to reach my goals. I likely will not make a change this year, but I have decided that I will likely implement a glide-path approach. With this approach, I will slowly begin to reduce my stock allocation as I near FI in an effort to achieve my desired asset allocation upon reaching FI. Of course, this is subject to change as are all things. As I continue to build my knowledge base through experience and continuous learning, I will make changes to my approach as needed. Like risk, my approach to investing is not static. It evolves and so do I.
References:
[1] https://www.investopedia.com/ask/answers/08/difference-between-risk-tolerance-and-risk-capacity.asp
[3] https://personal.vanguard.com/us/insights/saving-investing/model-portfolio-allocations