We know that investments can be focused on safety or on growth. That doesn’t help us to decide where in the safety-growth spectrum to place ourselves. Another complication, right? Actually, as this post shows, the key is to consider the extent to which good and bad outcomes affect our lifestyle.
How much investment risk can you tolerate? That’s what this post is all about.
Many investment practitioners and websites have created risk tolerance questionnaires. Depending on the answers you give to the questions in them, you end up categorized in a particular way (such as “risk-averse” or “moderately risk tolerant” or whatever) and assigned a particular allocation of different types of assets.
I’ve tried many of these questionnaires, and I’ve found most of them unhelpful. Partly it’s because their generic questions are too far removed from my own situation. But also, they’re questions related to investments, and frankly (even as someone whose career has been spent in that field) I think that’s virtually irrelevant. Most of us don’t have a gut feeling for whether a bad investment outcome is really bad or just a bit bad. But translate that bad outcome into the impact it has on our lifestyle, and then yes, we can tell whether it’s really bad or just a bit bad.
And that’s my point. Investing isn’t an end in itself. It’s only a means to an end. We should discuss risk in terms of the impact it has on your goals, on your desired lifestyle. That’s the language to use, not investment language.
That should also reassure you that there’s no right or wrong answer to risk tolerance. It’s just a question of what you’re most comfortable with – or perhaps least uncomfortable, because even though you may not be comfortable with any of the available choices, you still have to choose one.
In fact, your essential choice is to decide where you place yourself between two extreme goals: to eat well and to sleep well. I remember saying this to a group of pension fund participants, and it drew a round of nervous laughter. Surely that has nothing to do with investing! Surely it’s too simple a characterization! No, it’s accurate and not over-simplified.
Typically, those who are at the “eat well” end of the spectrum have a long-term focus. They want to accumulate enough wealth to be able, as the goal states, to eat well in retirement, to live their desired lifestyle to the fullest extent. They know, because they understand investment principles, that most of that wealth will come from the investment return (http://donezra.com/18-the-10-30-60-rule-shows-the-huge-multiplier-effect-of-investing/), and that, in seeking a high return over the long term, they must endure a high degree of short-term uncertainty and volatility (http://donezra.com/36-historical-investment-return-patterns/). But they are willing to do so, even though they also know that there is no guarantee that they will succeed.
Those at the “sleep well” end of the spectrum may also have a long-term focus, but they can’t live with that kind of uncertainty. They can’t sleep at night if their future seems profoundly uncertain and seems to vary in its prospects from day to day, with every gyration of the markets. So, even though they realize (because they too understand the principles in Post #36) that cutting back on risk also means cutting back on opportunity, they choose to live with low risk.
The choices are at opposite ends of the spectrum, because pursuing the goal of eating well compromises sleep.
Which end of the spectrum is more sensible? The answer is: they are both sensible. Being sensible isn’t a matter of seeing who ends up with the most money. It’s not a contest. It’s a matter of making a choice you can live with. And people are different, it’s as simple as that.
Most of us are probably somewhere between the ends of the spectrum. We’re not entirely risk-averse. Equally, we’re not willing to take enormous risk. We do know, though, that the biggest fear of retirees, according to surveys, is outliving their assets. Sleeping well is therefore the higher priority.
What determines a sensible place in the spectrum?
Essentially, there are two kinds of considerations. One is financial and one is psychological. We’ll examine them in the next post.
How much safety and how much growth should you seek? That depends on how you balance your goals of eating well and sleeping well.
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.