Four Ways of Assessing Risk
“Risk comes from not knowing what you're doing."
― Warren Buffet
“The greatest risk to man is not that he aims too high and misses, but that he aims too low and hits."
A Broader Risk Paradigm
At a dinner party one day I was chatting with a new friend and she mentioned how excited she was to have opened an account at one of the new online automated investment companies. After opening her account she moused through a few sliders, allowing the algorithm to peg her investment time horizon and risk tolerance. The computer then translated her inputs into an investment allocation and she assumed that she could now carry along with her life knowing that the power of compounding was on her side. She loved this idea of "set and forget." Curious, I asked her what she thought of risk and how the service had her invested. Turns out, when given the choice of putting money where she might lose it, or where there is little chance of loss she'd rather take the latter. She ratcheted her risk sliders back as far as they would go. Although she was single, in her early twenties, employed and had 40+ years before she would probably utilize the money, much of her portfolio was in low yield bonds, with very little allocated towards stock. A portfolio built this way will hopefully keep pace with inflation, but has very little chance of building a large nest-egg.
Understanding how scared someone is of losing money isn't the only thing that should go into forming someone's risk tolerance. It's actually just a small piece of the bigger picture. Let's consider four ways of thinking about risk. Taken together, they provide a more robust way of understanding how to build a portfolio- or have a human, or computer build it for you- in a way that will actually give you the greatest potential for success.
Let's look at the different questions each risk measurement asks, and how this can help us understand our investment strategy.
1) Risk Required
The question for our required risk is "what are my goals, how much money do I need to get there, and how fast does my money need to grow to get me there?" If I'm saving $200 every month to pay for my kids college in 20 years what rate of return do I need to get on that money to make sure I can pay for some or all of my children's schooling? Note that this question has nothing to do with my feelings about the stock market or putting my money where it is subject to loss. It's simply 'X dollars need to become Y dollars, how much should they grow?'
2) Risk Capacity
We address risk capacity by asking, what happens if I experience the potential downside of taking risk: loss? Intuitively, we understand that someone who is saving to buy a car next month probably shouldn't loan that money to a friend who is going to use it to flip a house. It gets a little more complicated as the timeline gets longer, or the target is moving. The risk capacity of someone who is going to retire in 5 years is one of those more complicated scenarios. On one hand losing 50% of their savings would be catastrophic. On the other hand, getting to retirement is not the goal. Having their money last through what could be 40 years of retirement is. Their risk capacity thus includes a significant element of capital preservation, but should also include a strategy for growth so they don't outlast their money.
3) Perceived Risk
When determining perceived risk we ask, how much risk do you think you are taking? Then we compare it to what the data indicates. In my experience most people's view of the risk their taking, and their actual risks are egregiously misaligned.
Very few people who bought homes in 2007 felt like they were taking significant risk. They looked around and saw that in recent years buying a home was a sure fire way to make money. In fact, they thought they were taking risk by not buying a home because they were going to miss out on what everyone else was doing and be left holding nothing while their friends cashed in. The same held true in the stock market run ups in 1929 and the early 2000s around the tech bubble. While people know that what goes up must come down, they have an uncanny bias towards discounting the potential downsides.
Inflation is another actual risk that people discount. Over time money held in cash becomes worth less and less. In 1968 you could buy a Big Mac for 49 cents. Now, it will cost you about $5.00. If you left that 49 cents in a checking account with no yield it is still worth 49 cents. You didn't risk losing any of your principle. But that .49 won't buy you much. If you instead risked all 49 cents by investing it, and for those 48 years received an annual 6% return, you would now have $8.03. You could buy your Big Mac and some fries too.
4) Risk Actions
Finally, classic risk tolerance focuses on how our feelings are translated into actions around risk. But the core is not the feelings themselves. Investors and their financial advisors have been told that what matters is a person's feelings about loss. That's only a small part of the equation. None of us feel good about losing money. It hurts. The question is, what do we do with those feelings? True risk tolerance asks, "What will you do when you experience the downside of market volatility?"
Only because that can be so hard to determine do investment advisors ask, "how do you feel about risk?" What they really want to know is whether you're going jump ship on your investment strategy when things hit the fan. If you had significant investments in 2008, did you change your allocation or switch advisors? If you noticed that the stock market dipped by 10% in the first couple months of 2016 did you consider selling some of your equity allocation, did you want to wait and see, or did you consider the market on sale and buy some more equities? Your actions, not your feelings, are what matter.
I hope reading this helps you start your own discussion. Unlike my dinner party friend who was told she can click a slider and forget the rest, you now have the ability to consider your required risk, capacity for risk, perceived risk, and actionable risk tolerance. It may not be as simple, but it gives you a lot better chance of making good decisions.