Risk Tolerance (Part 2)
Last week we looked at the concept of investment risk tolerance. We learned that there are three aspects to your true risk tolerance: Capacity (your situation), Perception (your knowledge), and Attitude (your emotions). Today we are going to look at how they shape the risk you should take in your portfolio. I thank Bob Veres (www.BobVeres.com) for his insight on how to explain this.
Scenario One. Let’s say that you have a portfolio worth $1 million, yet you only need about $10,000 each year from it to augment your pension and Social Security income. That represents only a 1-percent level of return. Even taking into consideration taxes and inflation, just about every portfolio allocation you can think of, from 100 percent CDs to 100 percent emerging market stocks, would produce the necessary growth to supply your tiny needs.
We can now look at your risk attitude to determine what portfolio is best for you. If you can emotionally handle the additional risk of stocks in your portfolio then you can do so and reap the extra returns. If you hit a snag (2008 being a snag) both your capacity for risk and your attitude toward risk will allow you to ride through it just fine.
Scenario Two. Then again, you may not have a pension. So let’s suppose your income needs were closer to $4000 each month. In that case portfolios consisting only of CDs, bonds, and other lower-risk securities will not provide the income you need, taking into account taxes and inflation. Here, you’ll likely have to move 50 percent or more of your portfolio into growth investments (think stocks). Only moderate or high-risk portfolios will keep up your standard of living.
In this scenario your situation will not allow the safer portfolios. Your risk capacity shows that you’ll need a portfolio with a preponderance of stocks in it and the risk (volatility) that accompanies them. This isn’t a problem if your risk attitude can handle a higher level of risk; but what if it can’t? This is a problem—and one you’ll have to deal with.
In the second scenario, if you pay attention to your capacity for risk and put more equities in your portfolio, what will you do when the market cuts stocks in half? Your risk attitude points to your propensity to sell in order to cut your losses. Even if your risk perception tells you that you should hang on until stocks recover, your emotions will be driving you in exactly the opposite direction.
I don’t know what you will do, but there are only two outcomes: selling and locking in a permanent loss or sticking with your holdings. The first will decimate your future standard of living. The latter will do the same to your mental health and potentially to your physical health for months or years. Neither are good options.
To keep this from happening, you’ll have some hard choices to make. My experience has shown that it is unlikely you’ll change your risk attitude. By now your psychology of risk is pretty much set. That leaves your capacity. You’ll need to change the situation you’re in. And that means either finding other sources of income (not easy) or cutting expenses (not fun).
On the other hand you could do what most people do…just ignore it. In that case you’ve wasted your time reading this column. Might I suggest the comics?
This article was published under the title "Risk Tolerance (part 2)" in the Wichita Falls Times Record News on August 23, 2009.