I’ve talked a lot about risk, particularly the impact of uncertainty in investment returns, all the way through. Here I’ll gather together a lot of those thoughts, give them names, and set them out in a way that gives you a framework for the sequence in which you can make risk decisions.
If you wanted to, you could spend a lifetime thinking and reading and learning about risk. You may also be asked by your financial professional to complete a risk profile, to assess various aspects of risk as they relate to you. So it’s surely useful to simplify the subject for you. Dr John Grable is co-author of a brief piece that defines many of the abstruse terms in use (risk tolerance, risk capacity, risk composure, and so on — seven such terms, in all) and I leave it to the enthusiasts among you to read it as an introduction and pursue the subject, if you so desire. But in this post I’ll simply visit the few essential angles that you’ll need.
Four, in all. Two are reasonably objective. Two are purely psychological.
Start with what’s called needed risk. As its name implies, this is a measure of how much risk you need to take (if indeed you need to take some risk). Why would you need to take any risk at all? The reason is simple. You might need to take some investment risk if you don’t already have enough money to do what you want to do. In other words, when you calculate your personal funded ratio (http://donezra.com/46-your-personal-funded-ratio/) it comes to something less than 100%. You have less than 100% of the amount you need to achieve your goal. Taking investment risk is one way to try to get there.
The more risk you take, the better your expected outcome. Of course, along with that is the unwelcome news that risk may also make your position worse than it currently is. (And it’s essential, as we’ve seen in the past and indeed will see again in this post, to estimate how much worse things could get if the outcome of taking risk is a bad one.) But how much risk you need in order to get your expected outcome to a funded ratio of 100%: that’s what “needed risk” measures. The immediate measure is how large a return you need. That then translates into what proportion of your assets need to be invested to seek growth. That’s pretty objective. Yes, it’s dependent on numerical definitions of your goal and your assets and the length of your time horizon and the return you expect from your growth assets. But all of those things can be quantified, and none of them depend on whether you feel good or bad about them.
The second objective measure is called your risk capacity. This tells you how much risk you can afford to take. How much money could you lose, and still achieve your goals? Or still find the loss acceptable? Again, you can quantify these amounts, without lamenting about how badly you feel if the loss happens.
Those may well be two measures that your financial professional will calculate for you.
And then your emotions take center stage. Remember (http://donezra.com/43-your-risk-tolerance-depends-on-psychological-and-financial-factors/), this is really the more important angle. And so now we come to the aspects that involve your feelings.
The first of those (and the third of the four angles I promised) is your risk tolerance. This is not the same as your risk capacity. You may be financially capable of withstanding a loss of (let’s say) $50,000 in the value of your assets, or (let’s say) a drop of $5,000 a year in your annual income after work. But you may not be willing to contemplate losing that amount of money. In that case, your risk tolerance is less than your risk capacity. “I don’t care if I could still survive after losing $50,000 or $5,000, I just don’t want to lose that much, and that’s all there is to it!” You can imagine how two people with the same calculated risk capacity may have very different risk tolerances, in that one may be willing to contemplate losing more money than the other, even if their financial situations and goals are identical. That’s why risk tolerance isn’t an objective measure. It’s very much a subjective measure.
We haven’t finished. There’s one more aspect to look at. And that’s the aspect of comparing what you say you can tolerate with your actual behavior if that loss really materializes. Let’s suppose, for example, that you say you can still live your life (not as happily, of course, but still get by) if you lose a maximum of $25,000 in asset value or its equivalent as a drop in annual income. And then, horror of horrors, it actually happens. Many people (probably most people) will be worse than horrified. They’ll be heartbroken. They will have discovered the phrase my friend John Gillies coined, that Risk has a friend called Pain. In assessing their risk tolerance, they considered risk as best they could; they imagined how they’d feel; and they came up with $25,000 as the limit of their tolerance. And now they have actually experienced it, and what hits them is not the abstract concept of losing $25,000, but the real feeling of pain now that it’s gone. For most people, experiencing the pain is far worse than contemplating the theoretical risk, no matter how much they try to imagine (in advance) how they’ll feel.
That’s where the expression risk composure is relevant. Risk composure is revealed when someone’s reaction to the actual pain is pretty much the same as the imagined (in advance) reaction to the possible loss. So it’s something revealed after the event. Obviously, if you have risk composure, you become a much more reliable person in discussing risk. And it’s not a precise measure, of course. It’s a sort of general assessment. It’s along the lines of “X is very/reasonably/not at all composed in his or her reaction to pain.”
The only way to assess your risk composure is to see how you’ve behaved in the past when outcomes were bad. That becomes an input to your risk profile, when your financial professional tries to help you to decide how much future risk you ought to take.
So here’s the sequence.
You and your financial professional do some initial calculations. Your professional tells you that you need some specific amount of risk, otherwise it isn’t reasonable to expect to achieve your goals. Associated with that amount of risk, if things go wrong, you could lose some specific amount of money (which might be measured in terms of assets or in terms of income to live on). If this is within your risk capacity, fine. If it isn’t, you really ought to seriously consider taking less risk, because frankly your goal is unreasonable, given your circumstances.
Either way, you move forward with either the original or a reduced amount of risk to take.
Then you think: never mind my objective risk capacity, how do I think I’d actually feel if that risk really materialized and I suffered the loss? Do I think I could actually live with it?
And if you’ve been through this sort of situation before, you and your financial professional can add: “Remember when we actually went through this? We discovered that the initial feeling of tolerance was (or was not) accurate…..”
And you amend, or go ahead with, your financial plan.
In practice you can estimate, reasonably objectively, how much risk you need to take in pursuit of a goal, and whether you have the financial capacity to withstand the consequences if things turn out badly. But you also need to think about how you’ll feel if things turn out badly, and remind yourself whether, in the past, your feelings were a good predictor of how you actually behaved when bad things happened.
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.