Risky Business
Steely-eyed killers are no strangers to risk. Ultimately, we stare down the risk that we might not come up initial as a 4-ship due to the dangers of even the most basic training mission. We face the risk of failing, getting fired, letting our troops down… there is almost no end to the risks we endure in military service. But how do we face up to investment risk?
Investing carries so many types of risk, that listing them all would either sound like Bubba teaching Forrest about shrimp recipes or a full reading of the “begats.” So, we might dive in on the risk that a company’s management might miss quarterly results, but it’s essential to start with the MK-1 human in the mirror first. As such, consider 4 types of risk as you determine how to invest.
Risk Tolerance
Risk tolerance is how well you sleep at night when the economic news is terrible. Do you want to bury your money in the backyard, or do you not even know that the economic news is terrible? If the former, you might think your risk tolerance is low. But there is a difference between wanting to bury your money in the backyard and doing it.
Investment advisors often measure risk tolerance with questionnaires designed by psychologists to tease out your risk tolerance. Compliance departments and regulators may love these questionnaires, but they are pretty flawed.
Risk questionnaires only capture your sentiment at a given moment. They ignore other essential elements of risk. If you’re 30 and score “moderate” on a risk questionnaire, your advisor might put you in a 60% stock, 40% bond portfolio, which might be far too conservative given your other risk components.
Risk Capacity
Risk capacity is how much money you can lose and still achieve your goals before the markets recover. If you have $100K for a house down payment and you need $100K to buy a home in two years, your risk capacity for those dollars is almost non-existent. If you invest $100K in volatile securities, you could lose all of it before the house purchase.
Given historical stock returns, most investors in the accumulation years (age 20 to nearing retirement) have very high risk capacity for most of their retirement portfolio. The market generally moves up and to the right… it recovers. As long as we stay invested, most accumulators have pretty high risk capacity for retirement dollars.
Risk capacity is not unitary. You probably have different risk capacity for your 529 college funds, TSP, and “purchase a de-mil’d Viper” fund. But if all your investments are in an S&P 500 fund, you maybe investing outside your risk capacity.
Risk History
Risk history is what you actually did during periods of market volatility. Did you sell to cash during COVID? Did you flee to “safety” in 2022? Did you sell and sit on the sidelines after 2009? What percentage of stocks and other highly volatile assets do you have your investments in today?
We might score low on an investment risk questionnaire but actually invest very aggressively in stocks and other volatile assets. If your risk history indicates that you weather the storms without flinching, that should factor into how aggressively you invest.
Risk Need
Risk need describes how aggressively you need to invest to achieve your goals. If you need $2M at age 65 to retire at your desired spending level, you might need to invest mainly or completely in stocks rather than bonds or other less volatile assets.
If you’ve “won the game” and could stop working and live off your investments today, you may no longer need to take much risk.
How to Use Risk
Knowing that there are at least 4 types of risk to consider is one thing. Synthesizing these risks to update your investments is another. The risk discussion often starts with a questionnaire, “Would you rather an investment of $100 that could lose $20 or an investment of $500 that could gain $100?” However, starting with your goals for your various piles of money may be more appropriate.
If we understand our risk need for college funds, retirement funds, and other mid-term goals, we at least know what an emotionless robot investor should do. Then, we can evaluate our risk capacity to see if we have the option to invest like said robot. After that, we can check six and realistically assess how we’ve invested in the past. If we stayed the course in the past, that’s a good indication of how we’ll do in the future. Finally, while questionnaires about risk tolerance are a least-worst tool, they invite us to consider our quality of life when the news is bad. Is an ulcer worth earning an extra 1% over 20 years?
Cleared to Rejoin
Investment risk isn’t unitary. Before choosing how much to invest in stocks and other volatile assets, we need to evaluate our goals (need), the timeline for growth (capacity), the likelihood that we’ll flinch (history), and an honest assessment of how stressed we feel when stock market news is terrible (tolerance). If you haven’t had a chat like this with your advisor recently, perhaps it’s time for a chat about risk.
Fight’s On!
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