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Gauging Investment Risk

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  • ajm184
    replied
    Ben Carlson wrote a relevant blog related to OP comment/question:

    http://awealthofcommonsense.com/2017/10/risk-perception-vs-risk-profile/?curator=thereformedbroker&utm_source=thereformedbroker

    He points out to very important points when it comes to risk (IMO anyway):

    a. You need to know yourself, behavior, reaction etc to risk in your portfolio.

    b. You need to be able to sleep at night with your portfolio.

    Leave a comment:


  • Arkad
    replied
    It is pretty easy to measure your risk tolerance vs. the risk in your portfolio. In retrospect that is. Until you live through a major drop, you will really never know.  I know many people who thought they had a high risk tolerance only to sell in 2008.  If you sell under those circumstances, especially with a long investment horizon, then you made a serious overestimation of your tolerance.

    Leave a comment:


  • q-school
    replied
    I have risk tolerance as far as not acting rashly in the market. But my wife will tell you I’m awfully crabby during the corrections. And I wonder if your patience changes as your progress to the winter season of your life and time is actually not necessarily on your side.

    Leave a comment:


  • ReFinDoc
    replied
    Term risk

    Liquidity risk

    Credit risk

    Single Stock risk

    Currency risk

    longevity risk

    etc.

    Risk is not Standard Deviation.

    Without risk, there can be no return, otherwise why invest in Stocks? "Risk" is a moving target.

    I use Sharpe ratios to ballpark ESTIMATE my risk. Otherwise I can't answer your question.

     

     

    Leave a comment:


  • Zaphod
    replied
    We are definitely our own worst enemies.

     

    Leave a comment:


  • ajm184
    replied
    Individual investor risk tolerance is one of the most difficult things to understand.  The questions to evaluate individual 'risk tolerance' are in my opinion only scientific 'for the moment', especially for those who are younger and have not experienced one or more full business cycles and their impact upon stock/bond valuations.  There maybe some more stability/reliability for survey/questionnaire result for those who have experience one of more full business cycles.  Also risk tolerance should be dynamic for individuals.  A challenge can be separating the risk tolerance dynamic from a particular financial decision.  A fallback/anchor is to equate risk tolerance with age versus potential outcome(s) due to a lack of information/understanding.

    As an FA/Asset Manager a basis of portfolio construction is an 'accurate' understanding of several factors including risk tolerance, time horizon, and CF contribution expectations.  If a client for example has a low risk tolerance relative to expected outcomes/end goals, the choice to the FA/Asset manager immediately become sub-optimal.  They can show expected outcome based on the factors provided and implement a portfolio that either requires a very high amount of additional contributions an expected outcome that does not meet the clients future needs.  Second choice is to 'educate' clients with respect their current risk tolerance and that the clients needs to 'trust' an FA/Asset Manager to adjust their 'risk tolerance'.  Maybe you 'educate', maybe you don't; but now the FA/Asset Manager is now the 'bad guy' every time something goes sideways in the market.  IMO these type of clients become the most needy, because though they may have acquiesced to 'trust me', but very likely not acceptance, let alone enthusiasm.  These clients need regular 'education' even if it is exactly the right portfolio to achieve the outcome/goal.  If something goes sideways, the FA/Asset Manager also has to question, is the clients 'risk tolerance' changing or is this a short term challenge to work through with the client?

    What little I have seen financial studies of millennials scares me. They lived through the financial devastation that '07 - '09 caused to themselves and their families.  Though they seems to have taken some great lessons from this time, avoid debt, live within your means, emergency fund; they as a group appear to have the risk tolerance that is more appropriate for folks in the 50's or 60's, money market in retirement accounts/bond funds.  The lack of risk tolerance can impede/limit their long term financial goals.

     

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  • Zaphod
    replied




    I don’t think the concern is the market giving up 10%, it’s more like when it gives up 50%.

    Are the questions how to you figure out your own risk tolerance and how do you measure the risk of your portfolio?

    The second question is pretty easy I think

    1. Look at the volatility of returns and correlations of the assets in your portfolio to come up with overall volatility for the portfolio.

    2. Stress test the portfolio based on the 2009 recession.


    For the first question, I think risk tolerance / allocation should be based on your goals and future savings.  My personal opinion is that you should be as aggressive in stock/bond allocation as possible without jeopardizing some kind of minimum level of nest egg for the future.  I posted an analysis in another thread, which I will re-attach here.

    In that case, the person had a 65/35 stock/bond split and $2.5M of savings and $1M of expected future savings.  I hypothesized that he might have a minimum need of $2.5M to retire that he did not want to jeopardize.  By keeping the 65/35 allocation, he would still meet his minimum retirement goal in a stress case, but would have at least $4.4M in an expected case with 6% stock and 2% bond returns, without even factoring in returns on his future savings.

     

     
    Click to expand...


    This is basically very similar to what Im talking about, looking at future/etc...and using that as your guide and reference. Just filling up that equity bucket first so that if a 50% event occurs it happens earlier and with a smaller portfolio than later, and later on with a much larger nest egg its not as risky on a time diversified view. People forget to look at the whole completed game for some reason. Its important and do this and with total earnings, etc...in talks to residents, etc...

    For example, you've been out a couple years and have 300k in retirement savings. You have estimated a future savings of 2.7M and a final allocation of 60/40 for your goal of 3M.

    60% of 3M is 1.8M, or 6x your current amount. Even a 50% drop would today would only be 8% of your final equity total. Seems concerning but not in context. An 8% drop is absolutely normal in great years.

    Obviously this is most applicable to someone starting out and without much of a nest egg already, as investing on a fixed AA basis slows your equity accumulation over time which subjects it to more risk and at the worst times (nearer to retirement, larger amount, less time to recover).

     

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  • Donnie
    replied
    I don't think the concern is the market giving up 10%, it's more like when it gives up 50%.

    Are the questions how to you figure out your own risk tolerance and how do you measure the risk of your portfolio?

    The second question is pretty easy I think

    1. Look at the volatility of returns and correlations of the assets in your portfolio to come up with overall volatility for the portfolio.

    2. Stress test the portfolio based on the 2009 recession.


    For the first question, I think risk tolerance / allocation should be based on your goals and future savings.  My personal opinion is that you should be as aggressive in stock/bond allocation as possible without jeopardizing some kind of minimum level of nest egg for the future.  I posted an analysis in another thread, which I will re-attach here.

    In that case, the person had a 65/35 stock/bond split and $2.5M of savings and $1M of expected future savings.  I hypothesized that he might have a minimum need of $2.5M to retire that he did not want to jeopardize.  By keeping the 65/35 allocation, he would still meet his minimum retirement goal in a stress case, but would have at least $4.4M in an expected case with 6% stock and 2% bond returns, without even factoring in returns on his future savings.

     

     

    Leave a comment:


  • Zaphod
    replied








    how to gauge the risk of a portfolio, e 
    Click to expand…


    I worry that many posters here do not have nearly the risk tolerance that they think they do.  It seems that most folks are 90-100% equities and have never been through a correction.  Maybe no one will panic but we will see.
    Click to expand…


    I guess that is what is driving my question.  Year ago I was trained to connect age to risk tolerance (that was pretty crappy training) and learned over the years there is no high correlation here.  I’ve been using Riskalyze for some time with my clients not only to figure out their risk tolerance but also to show them what their portfolios will do when there is a correction.

    It has been so long since we have had a real correction I do wonder what people will do.  It is like that old Mike Tyson saying that everyone has a plan until they get punched in the face.  How many 90% in equities will be able to hold the course when the market gives up 10%?
    Click to expand...


    I think this is where an advisor comes in most useful. Its really about trying to force people to think long term and in an overall sense. If you're not retiring for decades plus, you really shouldnt care at all and actually welcome it. If you're retiring soon, you should have a properly sized nest egg and allocation that means you dont care either.

    The issue is we dont talk about the risk of the other side though its no less real and likely more damaging. In the end you cant keep people from pulling the trigger which is the problem. Its never quantified properly and ranges arent given as to what your ultimate nest egg will be with typical allocations and time frames.

    Theres no difference in the risk of someone who is 100-200% equities in their initial stages of investing as opposed to someone with a fixed allocation like 70/30 when viewed over ones investment time horizon. There is a large dispersion in outcomes however. The person who starts out  (and obviously sticks with their plan, the you know hard part of it) will have higher average, median, and outlying return potential.

    We need to change our perception of risk from a snapshot to a more holistic view over your careers time span. Choose your ultimate risk and volatility parameters at your retirement age, but allocate it accordingly over your whole investment lifetime so as to capture more upside with the same risk. This means starting out all in equities, or even leveraged, and winding down until your basically buying your fixed income allocation heavily in the last few years while your equity portfolio remains steady. It was risked early on and had time on its side. Helps with sequence of return risk, etc...

    All about framing and education, and worst of all execution in reality. Thats where it all goes to ************************.

    Leave a comment:


  • djohnflatfeecfp
    replied





    how to gauge the risk of a portfolio, e 
    Click to expand…


    I worry that many posters here do not have nearly the risk tolerance that they think they do.  It seems that most folks are 90-100% equities and have never been through a correction.  Maybe no one will panic but we will see.
    Click to expand...


    I guess that is what is driving my question.  Year ago I was trained to connect age to risk tolerance (that was pretty crappy training) and learned over the years there is no high correlation here.  I've been using Riskalyze for some time with my clients not only to figure out their risk tolerance but also to show them what their portfolios will do when there is a correction.

    It has been so long since we have had a real correction I do wonder what people will do.  It is like that old Mike Tyson saying that everyone has a plan until they get punched in the face.  How many 90% in equities will be able to hold the course when the market gives up 10%?

    Leave a comment:


  • djohnflatfeecfp
    replied





    I try not to worry about a dollar or two price difference when years and decades from now it will be multiples of that price and I’d love to buy at these levels, etc… 
    Click to expand…


    What really fascinates me is how we obsess about a 5-cent per gallon increase or decrease in the cost of gas (myself included). Put in perspective, it is practically meaningless, yet we’ll drive an extra mile or to the next exit to save a 50 cents.
    Click to expand...


    So true.  When I started I did a lot of educational meetings for 401k plans.  We would often discuss how people would drive an hour to buy a $1,000 TV that was $50 cheaper but once the market pulled back 5% they would go to all cash.

    Leave a comment:


  • PhysicianOnFIRE
    replied
    I featured this Kitces article on risk in my most recent Sunday Best. It goes beyond perceived risk tolerance.

    "You may know your risk tolerance, or at least you believe you do. Michael Kitces of Nerd’s Eye View dives deeper discussing not only risk tolerance, but also risk capacity, and perceived risk in Risk Composure: The Real Predictor of Who Can Stick to Their Investment Plan."

     

     

    Leave a comment:


  • Zaphod
    replied





    how to gauge the risk of a portfolio, e 
    Click to expand…


    I worry that many posters here do not have nearly the risk tolerance that they think they do.  It seems that most folks are 90-100% equities and have never been through a correction.  Maybe no one will panic but we will see.
    Click to expand...


    Hopefully if they can frame it in appropriate life cycle terms they can handle it better. Best to keep auto funding on and never look really. Agree if you havent watched a position get obliterated, you dont appreciate the psychological aspects that come with it, and its nearly impossible to predict how you'll react. Its just very hard to take yourself while in a good spot and say...this is how I would react if things were 180 degrees opposite. Just cant accurately do so.

    I already know I wont be able to leave it exposed, so I plan for that now and try to set up barriers and procedures to keep my hands off or keep exposures to appropriate levels while still having cash for an opportunity.

    Leave a comment:


  • Hatton
    replied


    how to gauge the risk of a portfolio, e
    Click to expand...


    I worry that many posters here do not have nearly the risk tolerance that they think they do.  It seems that most folks are 90-100% equities and have never been through a correction.  Maybe no one will panic but we will see.

    Leave a comment:


  • Zaphod
    replied





    I try not to worry about a dollar or two price difference when years and decades from now it will be multiples of that price and I’d love to buy at these levels, etc… 
    Click to expand…


    What really fascinates me is how we obsess about a 5-cent per gallon increase or decrease in the cost of gas (myself included). Put in perspective, it is practically meaningless, yet we’ll drive an extra mile or to the next exit to save a 50 cents.
    Click to expand...


    Agree, even on a large 20 gallon tank its a dollar difference. Lots of things are less stressful if you view them in absolute type terms and if it really matters.

    Leave a comment:

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