Determining Your Risk Tolerance

“Risk is what is left over…after you have thought of everything.” – Carl Richards

“Risk is low when investors behave prudently and high when they don’t.” – Howard Marks

In the world of high finance, risk is a word you hear on a daily basis. Risk measurement, risk parity, risk controls, risk tolerance, risk-adjusted returns. Risk management is big business on Wall Street. Over the years the smart guys on Wall Street have come up with an abundance of ways to quantify risk.

They like to analyze risk through things like standard deviation, VAR (value at risk), Sharpe ratio, information ratio, downside capture, tracking error, Monte Carlo simulation and I could go on (don’t worry what these mean because to you as an individual investor they offer very little).

In the complex world of finance having quantitative tools to measure and manage risk helps analysts and portfolio managers track their exposures and look for possible problem areas within their investment portfolios and organizations.

But do these mathematical formulas really help them avoid risk? Or set their risk tolerance?  Not at all. Because the greatest risk when investing is the risk of the unknown. There is a saying in the investment industry that there are the known-knowns, the known-unknowns and the unknown-unknowns.

Basically, there will always be something to worry about when investing in complex markets. And it’s very hard to manage risk when it is unknown. It doesn’t matter if you are a PhD on Wall Street or an individual saving for retirement through a 401(k).  We all have to deal with the fact that we just don’t know how the future will play out, especially in the financial markets.

That is why it is best for individuals to spend most of their time focusing on qualitative risk factors as opposed to Wall Street’s quantitative confusing set of formulas and financial models (they can build all the complex models they want but at the end of the day it’s still garbage in, garbage out).

A simplified view of risk in investing terms is that higher risk leads to higher reward. That’s a tried and true relationship. You cannot receive a higher return on your investment without increasing your risk as well. All investments have some risk, but it comes in many forms.

Here are some general types of risks that you should worry about when investing: permanent loss of capital, downside risk (losing more than you can handle), upside risk (missing out on gains), loss of purchasing power (inflation) and not reaching your goals.

The last risk is the one you should be most concerned with because the risk of not reaching your goals has a much larger impact on your personal life than the volatility (standard deviation) of your returns ever could. To reach your goals and come up with an investment plan you must first determine your risk tolerance.

When defining your risk tolerance there are two main considerations you must keep in mind. There is your ability to take risk and your willingness to take risk. Your ability to take risk is based on a number of factors like your age, net worth, salary, future earnings power and time horizon.

Generally the younger you are the more ability you have to take on risk because you have a longer time horizon with many years to invest until retirement. Also you can assume that your salary will increase in the future so you will have the ability to replenish losses over time with your increased savings.

As you age and get closer to retirement you will need to use your investments to fund your everyday spending needs so your ability to take risk will decrease.

Your ability to take risk is fairly easy to determine. Your willingness to take risk is a different story. You may have the ability to take on fairly aggressive investment risk when you are young but might not feel comfortable doing so. So to sleep more soundly at night you may want to take on less risk.

Make sure you have a good balance between risk taking and sleeping well at night, though. You may think holding cash in a savings account is risk free but you have to worry about inflation eroding your purchasing power which could be detrimental to meeting your long-term needs.

In the book Hedge Hunters by Katherine Burton, there is an interesting story about rapper turned actor LL Cool J and how he invests his money. He stated to a hedge fund manager that he only invests in AAA-rated (the highest credit rating) municipal bonds and doesn’t reach for higher yield because that is what makes him comfortable.

So even though he has the ability to take on more risk through the fact that he has made millions in his career, he does not have the willingness and instead invests in a lower risk, tax-advantaged income strategy. Other wealthy individuals go farther out on the risk spectrum and invest in private equity, venture capital and other riskier strategies.

Obviously LL Cool J has more options since he has already accumulated his wealth, but this should give you an idea about how to compare your ability and willingness to take risk. Another take away is that he has an investment plan in place which works to reduce his risk of making irrational decisions with his investments.

Since you cannot control the risk of the unknown you must find other ways to reduce risk. Here is a list of ways you can control and lower your risk over time.

1. Have an investment plan in place: This includes setting goals and coming up with a strategy to determine how you will react to different scenarios in both the markets and life. Write it out so you can review it when you are thinking about making an irrational short-term move.

2. Diversification: Spread your investments across asset classes, geography and markets. You won’t hit the jackpot by diversifying but you won’t go bust either.

3. Asset allocation: Broadly speaking, this is the mix of stocks, bonds, cash, real estate and alternative investments in your portfolio. It will have a much larger impact on your returns than the individual stocks or funds you choose to invest in.

4. Rebalancing: Forces you to sell your winners and buy your losers to get back to your target asset allocation weights. You should do this periodically to stay within your stated risk guidelines that you determine in your asset allocation decision.

5. Dollar cost average: DCA is the best way to periodically invest over time to reduce risk. You will spread your purchases over a longer time frame and make the inherent volatility of the markets more beneficial to your cause.

6. Aligning investments with your time horizon: This goes with your plan and asset allocation but it helps to view each investment and goal through a lens of your time horizon to keep your risk in check. Your time horizons will range from very short-term (bills, emergency savings) to intermediate-term (house down payment, vacation) to long-term (retirement, college tuition).

7. Control your emotions: Put your finances on auto pilot and do not try to time the stock market. Having a plan with also help you stay away from the vicious cycle of fear and greed.

8. Keep it simple: Less is usually more when investing so stay away from complex strategies and products that you don’t understand. This alone will shelter you from tons of unnecessary risk and likely reduce your costs.

9. Save more: The more you save the lower your risk of not achieving your goals.

It’s OK to admit that you don’t know what’s going to happen, because no one does. What makes investing so difficult is the fact that we want to know all of the answers but markets will continue to remain unpredictable. Admitting that and moving on is a big step towards controlling your emotions and reducing your risks.  Determining your risk tolerance is the first step.