Thursday, January 24, 2013

Cutting Off The Tail, Part 2

Assessing Your Risk Tolerance Compared With The Risks You Run

In my last post ( I offered some thoughts on how to use various forms of insurance to mitigate some large downside risks that most investors face in real life.  Aside from insurable risks which tend to be characterized by low probability and high severity, every investor is confronted by risks which are much more likely and can have severities ranging from minor to extreme: portfolio risk.  Much ink has been spilled over the years on how to measure your risk tolerance and as far as I can tell it remains more of an art than a science.  In this post I will offer some thoughts on how to assess your risk tolerance and adjust your portfolio so that you only take risks you can live with.

So how do you know how much risk you can live with?  This is a much tougher question than it might seem.  I have seen numerous ways touted to help assess risk tolerance and they all fail to account for the emotional component of investor reactions when things are either looking really positive or in the pit of Hell.  This isn't necessarily a failure of the various questionnaires and other methods that are used.  Instead, it illustrates the difficulties identified by behavioral finance research of integrating emotional and non-rational aspects of human behavior with cold, calculating financial planning.  Inevitably, people become too exuberant and risk-tolerant when things are good and too risk shy when things are bad (or have been in the recent past).  So the same investor might give distinctly different answers to a risk tolerance assessment survey depending on what course the markets have taken n the recent past.  So while I think there is some value (they make you start thinking about risk) to many of the  commonly used risk tolerance assessments, until they integrate the emotional aspect of risk tolerance and/or compensate for it they will remain substantially flawed.

I don't have any magical way to fix the fundamental flaw that the risk tolerance questionnaires have.  Instead, I would suggest assessing risk tolerance another way.  Risk is usually defined as the risk that you will see the value of your investments decline for some period of time.  Given the tendency of most markets to have periods of time when they drop (sometimes precipitously) generally followed by a recovery, self-correcting price fluctuations may not be a great measure of risk for long term investors.  Instead, I think there are two forms of risk that should be contemplated and managed to the extent possible.  First, investors should be on guard for the risk that a specific investment or even an entire market may decline and never recover.  Clearly, an individual equity bears this risk, with the risk increasing as the underlying company risk of default increases.  However, there are also entire markets that are at risk of effectively never recovering.  A handy example is the Nasdaq index, which peaked at over 5,000 in the dot-com era and a dozen odd years later is still well short of that figure despite solid recent performance.  The risk of an investment or market never recovering is that you have a permanent loss of capital (as opposed to a temporary one which reverts to a gain if you are patient for a few months to a few years).

Aside from obvious situations like a stock issued by a firm with shaky finances, it can be challenging to identify situations where an entire market may be at risk of permanent losses.  However, valuation is usually a good guide so when you see record valuations it is probably time to start being cautious.  The risk of permanent losses from individual securities can be mitigated by diversification.  How should one diversify this risk effectively?  A very simple and highly effective way of doing so is to set limits on how large individual exposures can be within your portfolio.  For example, I generally adhere to a self imposed rule of having no more than 5% of my portfolio in a specific security at the time I initiate a position and no more than 10% at current market values (leaving room for appreciation).  So on a $1 million portfolio that would restrict cash used to buy a position to $50,000 and if the position appreciated to over $100,000 at market value I would be forced to begin selling down the position to stay with my 10% limit.  An appropriate limit might be different for each person, and I would suggest scaling the percentage limits based on how quickly you believe your portfolio would rebound from a total loss.  Clearly a portfolio composed of broadly diversified index funds would largely avoid the risk of a permanent capital loss and many investors chose to do so.

The second and more important risk is the risk of your portfolio failing to meet your goals.  Most investors have specific financial goals in mind, either for their portfolio as a whole or for segments of it (a college fund for your children, for example).  In the long run, the biggest risk investors face is failing to meet their goals.  Which matters more: seeing your portfolio drop 25% in a year and taking two years to recover the losses, or not having enough money to pay for the kids' college tuition or fund retirement?  Yet most risk measures and sensitivities are focused on the risk of short term portfolio drawdowns rather than the risk of failing to meet your goals.  I suggest that a good way to think about your risk tolerance with regard to the risk of failing to meet your goals is to consider the specific goals you have and the likely consequences of not meeting them.  For example, if your goal is to save enough to retire at age 55 and you miss that goal, most likely the consequence will be that you have to work for additional years to have enough saved for retirement.  How unhappy are you with that outcome?  If you enjoy your career and believe you will continue to do so, you might not be that upset to miss your goal and therefore be quite risk tolerant.  On the other hand, if you are counting he days until you no longer need to have a job, you might be fairly risk intolerant.

Fortunately, it is fairly obvious how to reduce the risk of not meeting your goals.  First, if you are not on track to meet your goal or wish to increase your chances of comfortably meeting it, you can contribute more to your portfolio out of your present income.  This is the simplest, most certain way to reduce your risk and it is entirely under your control.  Of course, this strategy has certain risks, most notably that you are giving up additional opportunities for consumption today in the hopes that you will be around to use the savings later.  "Tomorrow is promised to no man."  A second way to reduce the risk of failing to meet your goals is by adjusting your portfolio mix.  You might think that this is a suggestion to buy more bonds or hold more cash.  It is not.  Instead, the adjustments that reduce your risk depend upon how close you are to meeting your goal.  The farther away you are, the more willing you should be to take additional volatility risk if it comes with additional potential returns.  So an investor who is saving for retirement and has a goal of retiring in 20 years should be much more willing to see their portfolio drop temporarily if it means that they are likely to be rewarded for enduring the volatility.  On the other hand, the same investor who is a mere 5 years from retirement has less time to wait out such fluctuations and should seek to reduce portfolio volatility so long as they are still reasonably likely to earn a large enough return to meet their goals.

As a final thought, the above is by no means exhaustive and there are other risks that may be unique to your situation.  There are also lots of investors who are not cut out to endure high volatility even if it means pushing back their goals by a period of years.  If you know you will not be able to sit tight (or buy more) as the the markets go into one of their regular swoons, either find a way to automate things and don't look too often (401ks and similar programs are an excellent way to do so), reevaluate your goals to make them more realistic in the face of having to accept lower returns for volatility you can live with, or save more of your income to offset your reduced returns over time.  Unfortunately, there is no free lunch here, just a set of trade-offs to consider.

As always, the above is not intended as investment advice.  Consult your advisors, do your own due diligence, take your own risks and be careful.  There are no certainties in life except death, taxes and the fact that you will lose money on your investments from time to time.

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