How Much Investment Risk Should I Take?

This year has been a whirlwind of events, which has clearly been reflected in the stock market volatility. In February and March, we saw some of the biggest and fasted market declines in history, followed by 50 days of phenomenal performance. And now we’re beginning to see larger daily volatility, both up and down. These huge swings in the market have given a lot of people a good opportunity to reflect on their investment risk tolerance.

For the purposes of this discussion, when I say “risk”, I generally mean the exposure to equities, or more simply put, that breakdown between how much of your money is invested in the stock market (which will generally result in higher returns) and how much is invested in something safer like bonds or fixed income (which will generally result in lower returns). This is an important question for a lot of people. Should it be an 80/20 portfolio or a 70/30? When should I take more or less risk? The answer to these questions really depends on what we call “risk tolerance”.

When people say “risk tolerance”, they generally think about how much loss they can afford to take in their investment portfolio, or how much they can stomach to lose without feeling the need to get out of the market completely. While that's part of it, determining your risk tolerance is a lot more than figuring out what you can handle behaviorally.

When you're determining your own personal risk tolerance, which ultimately determines your “asset allocation” (that balance between stocks and bonds), there are three things that you should consider.

1. Need to take risk

2. Ability to take risk

3. Willingness to take risk

1) NEED TO TAKE RISK

Your need to take investment risk is really a function of how much you need to earn/accumulate to achieve financial independence; the more that you need to earn, the more risk you're going to need to take, and therefore, the more you may need to shift your portfolio towards equities versus fixed income.

Now, this is dependent on several factors like, how much money do you have saved away right now? How much are you actively saving? How much do you expect to spend during those non-working years of your life? What other sources of income do you expect during your non-working years, like social security or rental income? All of these are going to influence how much risk you need to take. For instance, if you already have a huge nest egg stored away, you probably don't need to take as much risk as if you were approaching retirement and you are just now starting to save. In which case, you’re probably going to have to put that money to work (i.e. take on more risk). The same concept applies to anticipated retirement retirement lifestyle; if you plan to live a relatively conservative lifestyle in terms of spending, then you probably don't need to take as much risk as if you plan to live lavish, expensive lifestyle during retirement.

Essentially, the more money you have yet to accumulate for retirement/financial independence, the more risk you’ll need to take in the meantime. Here is a simple chart showing this concept. This is by no means meant to be a recommendation or advice, it is merely a hypothetical chart showing the relationship between required return to meet financial goals and portfolio equity allocation. As you can see, there are many factors in determining your “need” to take investment risk, but it primarily depends on the amount that you need to earn in order to accumulate enough in to provide for your lifestyle during those financially independent years of your life.

2) ABILITY TO TAKE RISK

Your ability to take risk is primarily dependent on your time horizon—the amount of time you have until you’ll need to start withdrawing from your investment portfolio. If retirement/financial independence is 30+ years away for you, then you can likely afford to take more risks, because if and when the stock market crashes, you have plenty of time to see it recover before you actually need to start withdrawing that money to live on. On the other hand, if you have income needs now, or in the near future, you really can't afford to take that much risk because you're going to need that money to live on. And when possible, you’ll want to avoid withdrawing from a portfolio that is decreasing in market value (it’s basically compounding in reverse).

Here is a chart showing the relationship between time horizon and risk (equity allocation in your portfolio). Once again, this is not intended to be investment advice, rather, to provide a hypothetical example.

Basically, your ability to take risk primarily depends on the time horizon in which you plan to start withdrawing from your portfolio. The longer the time horizon, the higher your ability to take risk.

3) WILLINGNESS TO TAKE RISK

Your willingness to take investment risk is a very important one, and it's really dependent on how well you can sleep at night when there's volatility in the stock market. Reflecting on this past February and March (and even this month), ask yourself: Does the stock market performance keep me up at night? Am I stressed throughout the day due to the daily movements in the stock market? If so, then your willingness to take risk may be less than you originally thought. If the short-term performance of your portfolio is something you hardly think about, then you may have a higher willingness to take risk. And one is not worse than the other, it's just an important part of your overall risk tolerance. So this primarily depends on your personal temperament around market volatility.

RISK TOLERANCE = NEED + ABILITY + WILLINGNESS

Your true risk tolerance is really the balance between all three of these things. It's the intersection of your need, ability, and willingness to take risk. All three need to be in balance, because it's what ultimately determines what percentage of your portfolio should be in equities and what should be in something safer or less volatile, like fixed income.

There's no one right answer for everyone. While using a formula based on your age may get you part of the way there, it's only one piece of the puzzle. There are many factors that are uniquely independent to your specific situation. What's right for you may not be right for somebody else. For instance, you may have an ability to take on more risk, but you're not willing to; or, you may have a willingness to take on more risk, even though you don't need to.

Each one of these serves a unique purpose and is really important for your financial success. So whether you're working with an advisor or working on your own, it's critically important to understand yourself and your unique goals and circumstances, because there truly is no one size fits all.