Do You Feel Lucky, Punk? Determining Appropriate Portfolio Risk

Today, we’ve got a Saturday Selection from the White Coat Investor, where this article originally appeared. This is an important topic for investors, and it’s a great example of how personal finance is personal.

Some people are comfortable with risk. Others are conservative by nature. Some people avoid the stock market because they don’t understand it and consider it gambling.

Personally, I’ve never been afraid to take risk with my portfolio. I don’t take uncompensated or unnecessary risk, but I am willing to roll with the ups and downs of the stock market with a portfolio that is roughly 90% stocks.

How should you approach portfolio risk? Let The White Coat Investor guide you through the decision-making process.

 

Q. How Risky Should I Be With My Portfolio?

 

I don’t like watching the value of my investments going up and down—it feels like I’m in a casino sometimes. How much risk should I be taking with my portfolio?

A. The more investors learn about investing, the more they realize it’s all about risk management—and the risks you face matter far more than the past or projected returns of the investment.

“I am not so much concerned with the return on my capital as I am with the return of my capital.” — Will Rogers

However, it’s also important to not take on too little investment risk, as one of the most significant risks an investor faces is shortfall, or running out of money in retirement. The lower returns available on lower-risk investments may not allow your money to grow fast enough for your needs. There’s a reasonable range of risk for an investor to appropriately take, but there are far too many investors whose portfolios fall outside of that range.

 

RISK VERSUS REWARD

 

The amount of risk you take should be directly related to your need and ability to take risk. Most investors have a significant need to take on risk, but there are some who do not.

For example, an investor with a $10 million portfolio who needs only $100,000 a year from it can eliminate almost all significant risk from the portfolio and still meet goals. Most investors, however, aren’t nearly as fortunate. An investor with a $1 million portfolio who hopes to spend that same $100,000 per year needs to not only continue to add to the portfolio but also to take significant risk with it.

 

 

Risk Tolerance

 

Likewise, it’s critical to not exceed your risk tolerance. If you don’t have the emotional and financial ability to withstand a 50 percent drop in your assets (and few do), a 100 percent stock portfolio probably isn’t for you because once every 30 to 50 years or so, the assets of stock investors take a 50 percent haircut. [PoF: Or twice in the last 20 years!]

 

Save More Money

 

One of the best ways to lower the amount of risk you need to take is to save more money. Saving more of your income now has a double positive effect on your portfolio: Not only does it grow faster but the amount of income it needs to provide you to maintain your pre-retirement lifestyle is also lowered.

Consider an investor who makes $200,000 per year and is saving 20 percent of gross income in hopes of retiring on an income of $160,000 per year, including $30,000 per year of Social Security benefits. Using a 4 percent inflation-adjusted spending rate in retirement, that investor needs to work and save for 33 years prior to retirement.

By instead saving 40 percent of gross income and planning to live on $120,000 per year, including a $20,000 Social Security benefit, the investor now only needs to work and save for 19 years, which equals more than a decade of extra time in retirement.

 

Inflation Danger of Low-Volatility Low-Return Investments

 

Many investors prefer to invest in very safe but low-returning investments like CDs, bonds, savings accounts, and insurance-based products such as whole-life insurance. These investments appear to be safe because the returns aren’t volatile like those of higher-returning investments such as stocks and real estate.

In reality, though, they can be even more dangerous. Perhaps an investor’s greatest opponent is inflation. Even inflation of just 2 to 3 percent a year presents a formidable threshold to investments that yield only 1 to 2 percent a year. Nobody likes to see their investments drop dramatically in value, but the alternative is to be forced to spend less than you would have otherwise in retirement or face running out of money if you live long enough. Investors who prefer low-volatility investments have likely never run the numbers to really understand what their investment preference means.

For example, an investor who wants a portfolio to provide 50 percent of pre-retirement income but who achieves an investment return that only matches inflation (0 percent real return) and wants a 25-year career will require a savings rate of 50 percent of gross income for each of those 25 years. Very few doctors are willing to save that much of their income.

Alternatively, the investor can work for 40 years while saving 31 percent of income. A more risk-tolerant investor who achieves a return that beats inflation by 5 percent, on the other hand, would need to save only 25 percent of income for 25 years, or 10 percent of income for 40 years, to have the same retirement spending level. The bottom line is that almost all investors need to take on a significant amount of risk in order to meet their financial goals.

 

 

What is A Reasonable Amount of Risk?

 

Phil DeMuth, Ph.D., managing director at Conservative Wealth Management, LLC, has said, “Even if risk tolerance existed and could be measured accurately, why would it be an important factor when considering how to invest? You should invest in the way that has the greatest prospect to fulfill your investment goals. That might mean taking more or less risk than you would prefer. If you are a sensitive soul who can brook no paper losses, the solution is to get a grip, not to invest ‘safely’ if that locks in running out of money when you are old.”

There are many investing “products” (most of them insurance-based) that are marketed as reducing the risk of investing. However, these same products are also likely to reduce the return so much that a typical investor cannot afford to have any significant chunk of a portfolio in them. Financial theorist William Bernstein, MD, said, “There are no free volatility-reducing lunches that will inexpensively reduce your portfolio risk, and there is no risk fairy to insure the risky parts of your portfolio on the cheap. Yes, there are people who—and vehicles that—will do this for you, but they will cost you a pretty penny.”

 

Risk and Compensation

 

While the general adage that higher risk equals a higher return is true, you should be aware that you won’t be compensated for taking some risks. A risk that can be diversified away is, by its very definition, uncompensated risk. An example of this is investing in a single stock or even a handful of stocks. Since you can easily buy all of the publicly traded stocks in the world using low-cost index funds, you won’t be paid an additional risk premium for investing in a single stock—even if that stock is Apple.

A novice investor may ask, “What’s a reasonable amount of risk to take in a standard portfolio of low-cost, broadly diversified stock and bond index funds?” Many decades ago Warren Buffett’s mentor, Benjamin Graham, recommended never holding more than 75 percent or less than 25 percent of your portfolio in stocks, with the remainder in bonds.

I think that wisdom still holds true today, and you should have a very good reason to go outside that recommendation. If you do decide to leave the relatively safe confines of the publicly traded markets for your investments, limiting risk should be of the utmost importance in evaluating a prospective investment.

Owning stocks, bonds, and real estate isn’t gambling. You’re loaning money to or owning small pieces of real profit-generating enterprises, some of the largest and most successful that the world has ever seen. Make sure the amount of risk you’re taking on isn’t too much, or too little, to reach your goals.

 


Track your investments for free with Personal Capital. That's how I track the PoF portfolio.  

 

PoF: In my DIY investing guide, I’ve linked to five risk tolerance questionnaires in Step 4. I suggest you take one or more to help determine your risk comfort level.

How do you determine how much investment risk to take? Has that changed over the years? How and why? Comment below!

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10 comments

  • I personally try to balance the risk of my portfolio with assets that will provide a baseline floor cash flow that if all hell breaks loose I can still carve out a lean survival relying on this income without “locking in the losses” by having to sell an asset in decline.

    Yes when things spiral down my net worth will plummet which can be painful to watch but it really is not the final number that counts for me it is what that portfolio provides in yearly distributions.

    I have shifted my bond allocation to REITS because of this philosophy. Bonds are considered safe but have lower yields in this interest environment. REITS have volatility like stocks which typically is not what you want in retirement however by law they are required to pass 90% of their profits to the investor. As long as it has a reasonable payout when I am retired, I’m not so concerned with what the value is since I won’t be forced to sell it if the cash flow from all sources provides a decent enough floor to survive during downturns.

    I’m accentuating this philosophy with similar income producing streams most notably in private placement multifamily apt complex investing (it would take an apocalyptic event for shelter type assets to not have some demand)

    By doing these strategies I can be a little more aggressive in my portfolio for other assets

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  • WestcoastMD

    I wonder how many of the financial blog authors I follow rationalize Graham’s advice of “no more than 75% in stock” to their own holdings of 80-95% stock.
    Many have forecast the end of the “great bull bond market” that lasted 30+ years as interest rates fell from 16% to 1%. If the future only holds rate increases, my appetite for bonds remains low. Non stock alternatives to bonds remain few. rEITs or commodities seems like the wrong answer. They are more volatile than stock. Cash and CD are more mediocre. Precious metals or foreign currency may be a reasonable hedge but have their own pitfalls.

  • Gasem

    There are tools now that allow developing a portfolio which has the best return for the least risk. Dr DeMuth is correct if you are too risk averse you may not reach your accumulation goal, but OTOH you can pay for only a bit more return with too much risk. Too much risk means when the market crashes a heavy risk portfolio takes forever to recover compared to a more moderately risked portfolio, sometimes years longer. By the time the Big risker gets back to zero the moderate risker is already money ahead and back to compounding once again. In addition re-balancing adds to risk management by forcing you to buy low sell high into non-correlated assets, very important.

    The tools you can use are efficient frontier portfolio modeling which takes the guesswork out of diversification and asset mix. and monte carlo portfolio modeling, which allows you to “what if” scenarios on your specific asset mix. These tools which used to be in the domain of professional managers are now being mainstreamed. A full suite of these are integrated into personal capital and the Fidelity retirement planner. I wrote a couple primers appearing over on DoctorofFinanceMD.com to give a little heads up on how this approach to investing works. I had the kind Dr DeMuth look over my prose to make sure I didn’t miss anything.

    You will be saving for retirement for a long time understanding how to beef up your portfolio’s efficiency by controlling risk is just like finding free money.

    • My problem with the efficient frontier (and with those pestering agents at Personal Capital) is that you can maximize returns while minimizing risks looking backwards, not forwards. It’s a great thought experiment and should influence your decision making, but picking the optimal portfolio looking backwards has little bearing on the future. As evidence, looks at the performance of each year’s top quintile of mutual funds in the following year: those funds are way more likely to sink to the bottom quintile as investors chase backtested returns.

      I don’t really have too much of a beef here, but finding some point on the current efficient frontier is no guarantee that you’ve found the best return for the least risk.

      Ah shucks though, it’s a good place to start…

      • Gasem

        So what would you suggest?

        The efficient frontier merely uses an average of returns and standard deviations over a time period to try and eliminate jitter in the signal sample. It is a common technique used in signal sampling theory. If the sample is 6, 8, 6, 8, 6, 8 your average is 7 and 7 would be used in the calculation instead of 6 or 8. I’m not sure how that constitutes being backward looking. It merely constitutes being averaged

        • Gasem

          by the way your mutual fund example proves my point. The mutual funds regress to the mean in your example, same as the jitter in the standard deviation and return in my example, to give you a more accurate prediction. Your anchor in your example is to a ordering of mutual funds which revolve around a mean.

          What anchors the EF prediction, is the individual portfolio assets “risk and return” are fed into a quadratic or 2 dimensional calculation and are compared to a risk free asset typically a 1 month or 3 month T-Bill (essentially a zero point for the graph), so you can understand all of the relative risks and rewards in the analysis. Better calculators will eliminate assets that just cause noise or screw up optimization so you can feed 5 or 10 assets into the hopper but only 2 or 3 may get chosen to be optimized to give you best bang for the buck.

          What comes out is basically your portfolio becomes a synthetic “single asset” with a single synthetic “risk” and synthetic “reward”, the synthetic single asset is optimized for either best return for a given risk or best risk for a given return. and every point on the curve is an optimized pair of risk and reward for a varying asset mix of the best choice assets. Anything away from the curve is less than optimized and you are paying with excess risk for a given reurn. If you live on the frontier you never pay with too much risk for a given return. or pay for an inferior return for a given risk.

          • Look I think we agree on about 97% of this, but my point was that just because you pick an asset allocation that is on the efficient frontier today, it doesn’t mean that exact same portfolio is going to be on the efficient frontier next year, or next decade. In fact, it’s more likely to have drifted from the frontier precisely because people tend to group up towards the “best” allocation from prior years and that causes rising costs and underperformance in the underlying asset classes.

            My point with the mutual fund example is that people see the best performing fund and chase it. Because of the inflow of assets (hey, and regression to the mean, as you said), the fund is more likely to underperform in the future.

            My portfolio has an allocation with a historical return of 8.6% and historical risk of 13.2%. According to the efficient frontier, I could get 8.6% and a historical risk of 13.1%. Personal capital emails me all the time about the tragic mistake of my inefficient portfolio. I just think this is an illusion of precision that misleads people into thinking the future is more predictable than it is, and that causes them to take on more risk than they should.

            I’m not just talking about noise in the data, I’m talking about the future will not be like the past. Value stocks were terrible until they were great. International stocks were terrible until they were great. REITs are terrible this year and Commodities are terrific. The most efficient allocation in this moment is different than it was a year ago. I don’t think you should keep changing your allocation to try to stay right on the EF line. Use it as a guide, then stick to your plan.

            Anyway, it’s just my opinion, and I’m really not trying to be adversarial. EF is based on the past, and that’s not predictive of the future. But the truth that the efficient frontier represents the idea that diversified holdings reduce risk while maintaining return will be as true tomorrow as it was yesterday.

            Thanks for your reply, it’s given me some good things to think about!
            Mouse

            • Gasem

              Can’t do anything about your annoyance with PC and you are right the calculation is statistical and has some variance built in. My experience is the variance is more balanced and tends to oscillate around a mean but I invest in pretty strait forward kind of stuff. There is no difference between 13.1 and 13.2 but there is a major difference between 13.2 and say 10.2 That improved 3% risk over 30 years can mean an extra $300K on a $1M portfolio. If it’s only $250K because of some “drift” it’s still free money.

  • “By instead saving 40 percent of gross income and planning to live on $120,000 per year, including a $20,000 Social Security benefit, the investor now only needs to work and save for 19 years, which equals more than a decade of extra time in retirement.”
    I agree. This works. Although I didn’t have a fixed rate, my savings rate was about 38% of gross and 50% of net. I reached FI to produce $120K per year within 17 years of work out of residency. I now am dialing back the risk in my portfolio. I’m decreasing my stock allocation, lowering the small value component, purchasing real estate, shifting to strong credit rating bonds with short duration, etc. There is a time and place for risk and a season for reducing it too.

  • Sensible article doc. However, for those like me with a more “active” bent, I stayed with 100% stocks till late last year and then ratcheted it down to 60% stocks. I was able to do it despite paying very little in capital gains taxes due to deferred accounts and other special situations.

    I will now stay at 60% for a while till we see a sizeable correction of 10%+, at which point, I will move more into stocks back to 90-100%. If that correction doesn’t come in the next 2 years, that’s fine too, I will stay put with my allocation because I’ve captured significant gains from being in 100% stocks from 2012 till 2017.

    The point is about having no fixed rule – like 75/25 or 60/40 or even 100/0. Asset allocation should be dynamic based on your portfolio size, income needs and evolving risk tolerance/affordability, which isn’t static as many Fin Advisers assume.

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