We all have different risk tolerances. Some of us speed or text when driving, smoke cigarettes or drink alochol, skydive or climb to great heights, etc. Within each “risky” activity we engage in is a spectrum of tolerance. Investing in the stock market is no exception! “Knowing thyself”becomes increasingly important when deciding how to invest your money. In the wise words of George Goodman (AKA Adam Smith):
“If you don’t know who you are, this [the stock market] is an expensive place to find out.”
Risk vs. Reward
The fact of the matter is you’re going to have a hard time outpacing inflation (~3.15% on average since 1913) if you don’t engage in some sort of risk by investing money in the stock market. Consider the information on following chart, Figure 1, provided by Wealth Management:
Is cash really king in terms of returns when investing? Let’s put some context to the above chart by hypothetically investing 10,000 over 30 years :
- 100% cash @ 2.2% APR (Currently Ally Bank’s savings account rate):
- 90% bonds / 10% cash @ 5.1% APR
- 90% stocks / 10% cash@ 11.2% APR
If you haven’t seen it before, you can see how just a few percentage points (or fractions of percentage points) of APR compounds with a large enough time horizon. Don’t just focus on the “average return”, though! I would argue the most important column is actually the first one, “Largest Loss“, because bear markets are where investors find out who they really are. How would you stomach if your $10,000 endured the largest loss during those same time frames (note: the losses would actually be greater in the moment since the balance of the acct would not have be $10000 at the time of the loss):
- 100% cash @ 2.2% APR:
- $10,000 ($0, 0% loss)
- 90% bonds / 10% cash @ 5.1% APR:
- $9,580 ($420, 4.2% loss)
- 90% stocks / 10% cash@ 11.2% APR:
- $6,110 ($3890, 38.9% loss)
Turning $10,000 into six-figures sounds nice, right? BUT WAIT! Can you stomach watching 40% of the account balance essentially disappear overnight? Many people can’t, which is why you’ve got to be very honest and realistic with yourself when deciding your risk allocation. Think about how many people bailed out (sold their stock holdings at a significant loss in a panic and held them in cash) during the Great Recession 2007-09 and are now suffering the consequences of minimal growth since the market recovery. The key to capatilizing on the compounding growth of the market is NOT bailing out during bear markets. Instead, have faith in your plan and continue to invest/[rebalance] your portfolio according to your desired asset/risk allocation (outlined in your Written Financial Plan).
Jack & Victoria’s Asset/Risk Allocation
Victoria and I currently have an overall risk allocation of 80/20:
- 55% US Stocks (40% large-caps and 15% small-caps)
- 5% US Real-Estate Investment Trusts (REITs)
- 20% International Stocks
- 20% Bonds/Cash
In a future post I’ll dive in to the details of our portfolio and asset allocation, but for now just understand with an 80/20 risk allocation our portfolio is fairly aggressive.
How did we react during the most recent bear market?
Albeit brief, the market dropped around 21% between September and December of last year (2018). How did we react? Honestly, we weren’t phased, because we were comfortable with our risk allocation and offset some of that risk by diversifying into bonds/cash, international funds, and real-estate funds. We actually decided to tax loss harvest over $20k in losses that we can now write off on our taxes for the next several years ($3k/year); furthermore, we stuck to our guns with our asset allocation, continuing to reinvest and rebalance according to our written financial plan. As a result, not only have our previous holdings been recovering since the new year, but also the new holdings we purchased have grown significantly.
How do I know what my risk tolerance is?
You can’t. At least not until you’ve been through a bear market or two. I don’t believe in reinventing the wheel, so I’ll share an excerpt from Jonathan Clements book, “How to Think About Money” to get the conversation started:
“For starters, if you were investing in 2008 and 2009 [or the last quarter of 2018], check whether you bought, sold, or sat tight. Our memories are often unreliable, so dig up your old account statements and take a close look at the trades you made. While our investment savvy should improve over time, we shouldn’t fool ourselves: Probably the best indicator of how we will behave in the next bear market is how we bahaved the last time around.”
“What if you haven’t lived through a major bear market? Imagine the stock market fell 50 percent. Try thinking about the consequences in terms of raw dollars lost. Let’s say you have $500,000 in savings, including $400,000 in stocks. Suddenly, your $500,000 portfolio is worth 300,000. The money is gone and, for all you know, it isn’t coming back. Indeed, there is every chance your [now] $300,000 could soon be worth $250,000 or even less. How would you feel – and how would you react?”
So, how risky is too risky?
It’s your call. You’ll need to factor in contributions to your retirement portfolio and your investment horizon, but where to draw the line is ultimately up to you. I just hope you don’t find out the hard way where your risk tolerance begins and ends. I believe it’s better to hedge on being 10-20% more conservative than you believe you are and adjusting based on your response during bear markets.
What is your current risk allocation and why? Have you been through a bear market yet? If so, how did you react?