How Much Risk can you Tolerate and how Does that Affect Your Investment Portfolio?
It’s difficult to over-egg it – investment decisions are important; whether you are taking financial advice, investing via an automated investment platform or making individual investments yourself, your success or otherwise can have a material impact upon the quality of your life and your ability to achieve your financial life-goals – writes Christian Leeming.
In this article we revisit why it is important to know where you really sit on the risk/reward curve and what that means in terms of the construction of your investment portfolio.
It is all the more relevant on the basis that when it was first written, we invited the DIY investor to consider their emotional and behavioural response to a theoretical 20% slump in the market.
Then along came covid-19 and it all became horribly real; in Q1 2020 the FTSE 100 posted its worst performance since 1987, shedding 24.8% of its value.
Opening the year at 7,604, on the 23rd March the FTSE 100 closed at 4,994 – a drop of almost 35% that makes the ‘nightmare scenario’ we considered a mere bagatelle.
Many will by now have had their hopes or fears confirmed; no longer is this an academic exercise in behavioural finance or disaster planning; it happened and whilst some will be pleased they took the measures they did, many more will be anxious to ensure they are never again in that situation.
Back to Basics
I suspect that, much in the same way we became acquainted with ‘supply and demand’, at the risk of betraying my vintage, ‘risk and reward’ probably entered our lexicon at O Level time.
And it all makes perfect sense; the more risk you are prepared to take the greater the potential reward and the greater your potential for loss. Even ‘no risk’ – putting your money in a sock – comes with the risk that its buying power will be eroded over time by inflation.
Advisers, human or otherwise will assess your appetite for risk based upon a range of questions and you will find that you are a ‘3’ or a ‘5’ which in turn suggests an asset allocation that is right for you; but where does a churning stomach or night-sweats appear on the spectrum as you fret over a volatile market or change in personal circumstances?
Risk in the context of asset allocation is broadly the balance of shares (no guarantees, potential volatility) and bonds (guaranteed income, greater stability) in your portfolio.
A correct assessment of your appetite to risk can prevent an emotional and expensive ‘sell’ response when markets fall, and whilst filling in a questionnaire may churn out a ‘score’ you may only really ‘feel’ what your level of exposure is when markets turn bearish.
Learn From the Past
Markets are cyclical and even if you have not experienced a 20% downturn in the value of your portfolio, there will be someone willing and able to share their experience.
One of the most damaging and costly reactions to a downturn is a knee-jerk sell off which will almost certainly be done at a knock down price; whist emotion can never be fully excluded, this can be controlled with a risk assessed asset allocation.
If anything it is probably better by starting off too cautiously; taking a hefty blow to an equity rich portfolio may ward the investor off the asset class for good, thereby depriving them of the inevitable gains that will be along at some point in the cycle and leaving too much heavy lifting for the bonds to be able to meet the investment objective.
In response to a 20% downturn:
- If you panicked and sold up then your asset allocation is too aggressive; you are likely to have a low or very low tolerance for risk and should reduce the proportion of equities you hold in favour of fixed income – bonds.
- If you were worried but held firm without undue duress, you probably have a moderate appetite for risk that can cope with that level of loss.
- If you saw the downturn as an opportunity to pick up equities at knock down prices, then your risk tolerance is high
- If you hoped for further falls to throw up more bargains, you have a very high tolerance!
William Bernstein in ‘The Investor’s Manifesto’ suggests the following when constructing a risk-assessed investment portfolio:
Your bond allocation in percentage terms should equal your age; older = safer.
Your equity allocation is then adjusted higher or lower according to your reaction to the bear market scenario described above:
Very High Risk – increase equity allocation by 20%
High Risk – increase equity allocation by 10%
Moderate – age = bonds%; balance = equities
Low Risk – reduce equity allocation by 10%
Very Low Risk – reduce equity allocation by 20%
So, a high risk 30-year-old would be 80% in equities and 20% in bonds; a low-risk 60-year-old would go for 70% bonds and 30% equities.
Changes in your personal circumstances, attitude or confidence may allow a little tinkering with the equity/bond mix over time, but beware allowing the siren call of a protracted bull market to drown out your natural caution.
A cautious approach may enable you to grow in confidence, but that first loss, when it inevitably comes, will still feel pretty bad; the key is to be prepared and able to ride it out as a paper loss until things improve – the UK market saw 33% of its value wiped out in 2008, and eight years on the FTSE 100 was at near record levels.
Passive investments champion Monevator suggests trying the following:
- Write down the equity value of your portfolio.
- Halve it.
- How would you feel if that’s the amount you had in six month’s time?
- How would you feel if it took 10 years before your equity portion recovered its original value? Would you hate yourself? Would you feel stupid? Sick?
- If so, repeat again only this time you lost 25%. Then 20% and 10%.
- Can you cope if your portfolio doesn’t recover for 10 years?
- Dampen your portfolio with bonds or cash until you reach a position you can live with.
Based upon your response to the above exercise, academic Larry Swedroe suggests the following asset allocation model based upon the addition of government bonds to mitigate against an unwillingness to accept losses.
|Max loss you’ll tolerate
|Max equity allocation
Even the most carefully constructed portfolio will be side-swiped by extreme market conditions; a 50:50 portfolio of UK equities and bonds went down by 58% in 1973 and 1974 and no increase in the proportion of government bonds was ever going to plug that gap.
Risk tolerance is also something that changes over time and particularly as the investor looks for more certainty as they approach, or are in, retirement when they have more to lose, and less time to make up any losses they incur.
It is important to remember the emotions of a big loss or the euphoria of a continued purple-patch and aim for an asset allocation that makes the former feel less onerous and the latter all the more joyous; but neither out of the ordinary.
Once you are at peace with your attitude to risk, it is important not to let circumstances knock you off course; chasing losses by opting for riskier investments is a sure fire way to undo a lot of hard work – particularly when you are closing in on your goal.
As you near the finish line, reducing the equity portion of your portfolio will reduce your risk and if you need all of your capital back within the next five years then you probably shouldn’t be in equities at all; another rule of thumb is that equities could lose half of their value at any time, so see what such a loss would do to your projections.
Regardless of your certainty that your risk assessment is accurate, re-visit it over time, and be sure to do so where you have signed up to a platform that has no provision to change your asset allocation as circumstances and attitudes change.
If your appetite to risk is correctly assessed and your asset allocation is in tune with it, your investments should give you no sleepless nights – DIY investing is about accumulating and managing wealth over a long time horizon; it is not about punting on binary options, a bête noire of the money pages.
Because it’s a marathon and not a sprint, if your risk assessed portfolio is well constructed, you should be able to resist the temptation to sell cheaply when markets inevitably nose-dive and be ready to capitalise when the correction comes along.