Today’s post is about Risk Tolerance. How can we as Private Investors work out objectively what our risk tolerance is?
One of the few nice things about using an independent financial adviser is that they ask you a lot of questions, and then they objectively analyse your answers in order to work out what kind of investments are most suitable for you.
Obviously they will charge you a fortune for this, and may well end up recommending things which reflect their own prejudices as much as your needs.
- And it may be that they only get you to fill in these forms to avoid you taking them to the ombudsman when you don’t get the advice and investments you expected or wanted.
So just be clear, we’re not suddenly suggested than you visit a financial adviser.
But this analysis is still something that is missing when you go your own way as a private investor.
- Some of this work concerns where you are today (your financial position) and where you want to get to (your goals), but what I want to focus on in this post is your attitude to risk.
How can we objectively analyse ourselves so as to come to the same conclusions as the professionals would?
As luck would have it, I’m subscribed to a few sites and magazines aimed at IFAs (and their US equivalents), and there have been a few recent articles covering best practice in this area.
Often these articles come in the form of CPD – continuous professional development.
- In other words, the pros that you need to pay hundreds of pounds an hour in order to access get to read magazine articles and call it training.
And many of these articles contain nothing useful in terms of how to measure risk, but instead provide checklists for how to demonstrate you followed best practice (ie. orthodoxy) in putting your risk questionnaire together.
- That sounds like a recipe for group think and eventual mis-selling to me.
A similar argument can be made against the over-regulation of robo-advice.
- The more that providers are forced to demonstrate that they are following “best practice”, the more they will act as a herd and the less scope there is for value-add.
Today I’d like to turn the tables and use these CPD and other articles to pick the brains of the professionals and try to work out what to do for ourselves.
You should evaluate situations where risk is involved using the concept of expected value.
- Risk here means uncertainty, rather than volatility as it is often assumed to mean in investing.
If we know the probability of something happening, and the rewards (returns) to us when it does, then we can work out our expected returns (expected value, or EV).
- Thus for a coin flip, we have a 50% change of winning 1 point, and a 50% chance of losing 1 point.
Our EV is 0.5 * 1 + 0.5 *-1 = 0
- So we should see no difference between playing this game and being paid £2.50 without playing.
- What we actually prefer reveals something about our approach to risk.
Gary talks about three dimensions in our approach to risk, though they seem closely related to me:
- capacity, and
Aversion is to do with avoiding big losses.
- If we increase the stakes to £10K for a win and losing £5K if we call wrong, the EV is now £2.5K per toss.
- That’s still an average 50% return on what we are risking (£5K), but now the absolute numbers are much bigger.
Lots of people wouldn’t like to lose that £5K1
- These people would accept a smaller certain return in order not to have to play the game and risk their £5K.
There will even be some people who will pay money not to play.
- These are the people who like to buy insurance against risks, rather than self-insure and save the insurer’s profit margin.
- They might also be the people who are currently buying bonds with negative yields.
Risk capacity seems to be the way in which our aversion is driven by the size of our outcome relative to our net worth.
- Essentially its our ability to take the hit by drawing on our existing reserves.
- We should be able to endure the loss, and still have the possibility of achieving our long-term financial goals in the future.
Even poor people (or rather, especially poor people) are willing to play the lottery at poor odds for the chance to change their situation, because it only costs £2 to play.
- This also explains why anti-insurance people like myself are happy to insure our houses against fire or collapse, since that is just too big a hit to take.
It’s also clear that some investors will have the capacity to take risk – and indeed, may need to take risk to achieve their goals – but won’t be willing to actually take the risk.
- The vast number of long-term savers in the UK whose principal vehicle is the Cash ISA spring to mind here.
Risk tolerance apparently has an ISO definition (within the Personal Financial Planning Standards – presumably a US framework – number 22222).
- It is “the extent to which a consumer is willing to risk experiencing a less favorable financial outcome in pursuit of a more favorable financial outcome.”
As Gary notes, loss aversion means that this tolerance is not symmetrical.
- We’re much happier to risk our winnings that incur losses.
- We’ll trade £1.50 or even £2 of gains to avoid £1 in losses.
Risk tolerance is a relatively stable personality trait, but changes with mood and age.
HOW TO MEASURE IT
Unfortunately, measuring risk tolerance is the hard part, partly because the regulators hardly ever specify how to do it.
- In particular, they don’t provide an academic framework (the equivalent of Modern Portfolio Theory when assessing investment choices) against which to measure the approach to risk.
- Michael Kitces wrote about this a few weeks ago.
Like Gary, Michael also separates risk tolerance and risk capacity.
- He also adds risk perception and risk “composure” (the stability of an investor’s attitudes to risk) to the mix.
Risk perception is simply how risky an investor perceives an investment to be, relative to the average perception of other investors.
- I might see emerging markets equities as moderately risky over the medium- to long-term (based on their historical drawdowns) whereas many investors (US investors for example) would never consider them.
- Plenty of investors – let’s call them savers, to be more accurate – won’t touch stocks at all, though they find buy-to-let property and P2P lending perfectly acceptable.
NOT WHAT I SAY
Another problem is the gap between what people say about their attitude to risk and what they do in reality.
- Some people will panic sell in a crisis, while others will sit tight.
We are all much more likely to describe “idealised us” when calmly completing a questionnaire.
- What we do when real things go wrong may be different.
And the investing history of a PI will feed into their future decision-making, in the form of anchoring.
No-one likes to make a loss, but it helps if you do so after having just made a much bigger gain.
- So an investor who has just ridden a bull market may happily sit through the following bear, since he’s only losing “house money”.
- The same goes for someone who is investing an inheritance rather than their own hard-earned cash.
- Whereas an investor who got in to the bull market late may sell everything once stocks fall 20%.
It almost goes without saying that investors who are not well-educated (financially) or who are not experienced (eg. have not been through a bear market, perhaps because they are too young) are likely to be worse at predicting their future actions accurately.
Michael advocates a combination of psychometrically designed risk tolerance questionnaires to assess an investors attitudes to tradeoffs, and standard IFA interviews to assess risk capacity and goals.
- The IFA would then assess the investor’s ability to achieve their objectives given the constraint of their risk tolerance.
From a DIY perspective, the IFA interview would be another questionnaire (or in practice, a simple spreadsheet) documenting the present and desired future financial positions.
- And the investor themselves would need to assess how likely the goals were to being achieved given the amount of risk they are prepared to take on.
It’s clear this won’t be easy, but doing something is almost always better than doing nothing, so let’s try.
RISK TOLERANCE QUESTIONNAIRES
Unfortunately, there aren’t that many risk tolerance questionnaires (RTQs) in the public domain.
- I guess that’s to be expected from such a smoke and mirrors industry.
I’ve managed to find three, though, along with a couple of academic papers that discuss their construction and shortcomings.
- I’ll be back in a week or two with a composite questionnaire that you can use to test your own risk tolerance.
THE SIMPLE APPROACH
For now, you could always rely upon the simple rule of thumb concerning losses.
Risk tolerance is generally used to feed into asset allocation.
- The number one decision within asset allocation is working out the proportion of stocks you are willing to hold in your portfolio.
Over the investing career of the average private investor, you can expect to go through three or four serious equity market crashes, where prices fall by 30% to 40%.
- So if you can work out what proportion of wealth you can afford to lose, you can work out what proportion of stocks you can afford to hold.
To keep the maths simple, if you can afford to (temporarily) lose 20% of your wealth without panic selling, you can sleep at night with 50% of your portfolio in stocks, since 50% of the 40% maximum equity drawdown is 20%).
- If you can afford to lose 30%, then you can hold 75% stocks (75% of 40% is 30%).
If you want to be extra conservative, you can use 50% as the maximum equity drawdown that you are likely to see.
Until next time.
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