﻿Risk tolerance and asset allocation. It doesn’t get any more fun than this. Hi if you are new
to the channel, my name is Tae from Financial Tortoise. In this channel, I discuss personal
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Gretchen Rubin, the author of Four Tendencies, talks about how “Self Awareness is Key to Self
Mastery.” In the same way, when it comes to mastering your investments, knowing your risk
tolerances is akin to self awareness. Only when we know how much risk we are comfortable with,
can we apply that to setting up our ideal asset allocation and become a successful investor - one
that is aligned to our personal preference and natural inclination. Are you the type that is
so risk average that despite having billions of dollars, you keep it all in a bank savings account
despite its ridiculous 0.03% interest rate? Or are you an extreme risk taker? Who thinks nothing
of investing hundreds of millions of dollars in speculative investments. And even at the brink of
bankruptcy, you have no trouble sleeping? Most likely, you are probably somewhere in between.
But the most important factor is that you have the self awareness to know where in the spectrum
you fall. On October 9, 2007, the Dow Jones hit its high and closed at 14,164. By March 5, 2009,
it had dropped to 6,594. More than 50%. For those of us who owned stocks in a severe bear market,
we have all experienced this dilemma - should we sell? Regardless of how we may think we
will behave in such an unnerving situation, it's really hard to predict how we will really behave.
And whether we like to believe it or not, there almost certainly is some point during a market
decline when we all have considered selling. Just imagine. You are in a severe bear market
and you are watching your hard-earned money steadily erode week after week and month
after month. People are talking about gloom and doom all around you. You have no idea
how much further your investment will drop by. Should you sell now to cut your losses?
How much longer can you endure when the news is constantly proclaiming that the market will
only go down further? Everyone is saying that the worst is yet to come. And to make it worse,
your friends and family are selling their shares and are encouraging you to do the same.
In such a scenario, what would you do? Will you sell? Or do you stay the course?
Such a scenario was what millions of Americans were dealing with during the 2008 financial
crisis. It seems like there was no limit to how far a stock could fall. And when panic sets in,
our emotions take over and they become our worst enemy when it comes to investing.
But a good, solid asset allocation will be your best weapon against such situations.
A good asset allocation that is aligned to your risk tolerance will help you resist
the temptation to sell funds in a declining market. You can honestly tell yourself in a
down market that - No, I am not going to sell because I learned that the US market
will always recover and my asset allocation is suitable for my risk tolerance. A popular method
that many people recommend to help determine if your asset allocation is really right for you
is what’s called the “Sleep Test.” Once you have set up your asset allocation,
ask yourself, “Can I sleep soundly without worrying about my investments with this specific
asset allocation?” The answer should be yes. Stocks and bonds naturally have their cycles of
up and down and we all need to be comfortable with that fact. Experienced investors understand this
cycle and volatility. And we know that by simply changing our allocation between stocks and bonds,
we can reduce the level of volatility in our portfolio until we reach our ideal sleep level.
But you and I are investment nerds, so we like to take it a step further with a more objective
method than just a simple sleep test. So, let me go over 5 key factors you should consider when
determining your risk tolerance. Number one factor is your income. Your personal financial situation
is one of the key factors you want to consider when determining your asset allocation plan. For
example, if you have a stable job with consistent income, you may be ok with taking greater risk
in your portfolio. However, if you don’t have consistent income because you are in a contract
position or have your own business, you might want to take a more moderate or consersative risk
stance in your portfolio. Another factor you want to consider is the time frame to withdraw. Stocks
are usually unsuitable for short time frames. Think less than 5 to 10 years. For example,
let’s say you are investing for retirement. Which is in 2 to 3 years. If you had your investments
all in stocks and the market tanked, like it did during the height of the 2008 financial crisis,
your portfolio would be worth only about half its previous value. Stock market ups and downs become
less and less when the investing period lengthens - reversion to the mean. Stocks are actually
poor investments for short-term, but excellent investments for long term because of this. So
therefore, if you are needing to withdraw your money within a few years, your risk tolerance
would be moderate to conservative. Whereas, if you don’t need to withdraw the money for
the next few decades, you should be ok with higher risk tolerance given you have time on
your side for reversion to mean to work its magic. A third factor you want to consider in determining
your risk tolerance is personal obligation. Are you a single guy or a girl with no other
individuals dependent upon you financially? Or do you have a large family where people are
depending on you to financially provide for them? If you have no other individuals depending on you,
you can have higher risk tolerance given you have the ability to taper your lifestyle down
if the market is in a bear market. Unless you have an especially expensive lifestyle,
you have the ability to move to a cheaper location, eat rice and beans for months and
take public transportation to work. Now, do you want to? Likely not if you don’t have to. But
if it is just YOU that you need to feed and take care of, you have that option. Now, if you have
family members - spouse, kids and aging parents that might be depending on you, not so much.
You can’t just pick up and move to a cheaper cost of living location. Your kids likely wouldn’t want
rice and beans every night. And it would be quite strenuous trying to move a large family in public
transportation. It can be done - but not easy. So if you have personal obligations beyond yourself,
your risk tolerance may be lower than someone who has no other obligation than themself. Your
financial goals are another factor you want to consider when determining your risk tolerance. Is
your financial goal to become a deca millionaire one day? To rub shoulders with the rich and
famous? If this is your desire, then you must get comfortable with risk. All wealthy, and especially
the ultra wealthy are masters of risk taking. And because they took risks, they were handsomely
rewarded. If your financial goal is to amass a large fortune one day, holding 100% bonds will
not get you there. It’s like trying to drive cross country with your parking brakes on the whole
time. But let’s say that your financial goals are more moderate. You are ok with amassing some
wealth, but just enough to be comfortable. And comfortable is a subjective description, so I’m
talking about simple comfort. Roof over your head. Ability to put food on the table. Simple things in
life. In that case, you might be ok taking less risk. And your risk tolerance could be lower
because your financial goals don't require you to take on big risks. The 5th factor to determining
your risk tolerance may be the most important. And that is your personal tolerance to risk in
general. In other aspects of your life, outside of money and investing, how do you approach risk?
Are you the type that loves bungee jumping in the jungles of remote Brazil? Or do you never jaywalk,
even in your own neighborhood where there are hardly any cars? And when it comes to investing,
how would you feel if the market dropped by 30% tomorrow? Are you the type of person that can
emotionally weather that kind of a dip? Or would you have a hard time sleeping? Take a look at the
chart here I borrowed from the Bogleheads Guide to Investing. This chart shows maximum annual
loss and the average annual return an investor would have incurred during the period from 1926
to 2012 based on various stock to bond allocation. Now imagine you were 100% in stocks because
you believed your heart is made of steel. At its worst year, you would have lost 43% of your
portfolio. Are you ok with that? If not, at what level of worst case scenario would you be ok with?
Only you can answer that, and you need to look hard at yourself to determine your ability to
tolerate risk based on all the factors that we considered so far, your income,
time frame, obligation and goals in combination with your personal risk level.
Alright, now that you have a general idea of where you might stand with your risk tolerance,
let’s apply that towards building your ideal asset allocation. There is a wide range of
risk tolerance and how it can translate to asset allocation, but for simplicity's sake, I’m going
to use three levels. First level is Conservative. If you are conservative with your risk tolerance,
you don’t like volatility and you would never even think about bungee jumping in the jungles
of Brazil. You hardly like crossing the street. Second level is Moderate. If you are moderate with
your risk tolerance, you are ok with some level of volatility and you might go bungee jumping.
Sometimes. But maybe zip lining is more your type of sport. The third level is Aggressive.
If you are aggressive with your risk tolerance, you love volatility. Because that means more risk
and more reward. And you would not only go bungee jumping in the jungles of Brazil, you
want to go skydiving in New Zealand afterwards. Ofcourse, I’m exaggerating here, but these three
levels of risk tolerance are good reference points for our discussion. The probability
is that your personal risk tolerance and asset allocation should fall somewhere in between.
And when it comes to constructing your portfolio, I’m going to talk simply about the combination of
stocks and bonds. A good analogy I like to use with stock and bonds is that stocks function as
your core wealth building engine. Without it, you aren’t really going anywhere. And bonds
are like your breaks. Without it, you could drive yourself off the road. When you have bonds in your
portfolio, it helps to smooth out your investment ride because though they have lower returns,
they have less volatility. Stocks of course should be made up of total market index funds like VTSAX
and bonds should be made up of total market bond funds like VBTLX. At times, we will read or hear
about investors claiming great returns from exotic sounding securities - gold, options, commodities,
crypto or NFTs. My advice is to forget about them. Especially as your core
portfolio holding. Most of these investments are highly complex, and not for good reasons.
And oftentimes heavily sold to investors who have little understanding of risks involved.
A general rule of thumb I like to use is, I don’t buy anything I can’t explain to my 12-year nephew.
Alright, now what could a stock to bond asset allocation look like for each level of risk
tolerance? If you are aggressive with your risk tolerance. Meaning you actually embrace volatility
and have a long time horizon for your investment, a 90/10 Stock to Bond ratio might be ok for you.
You might even be able to push it to 100% in stocks if you really want to be aggressive. And if
you are in your 20s or even 30s, I would actually recommend this given you have time on your side.
When you are young, risk is your friend. Don’t shy away from it. Now, let’s say that you are
more moderate with your risk tolerance. Meaning, you are ok with volatility, but because maybe you
have a large family or your income isn’t as consistent, you don’t want to be so risky. Here,
a 80/20 or 70/30 stocks to bond ratio might be best. You have enough stocks to take advantage
of the market, but also enough bonds to smooth out the ride. If you are in your 40s or 50s,
you might be in this bucket. Alright, let’s say you are conservative with your risk tolerance.
You are in the later stages of life so retirement is right around the corner.
You don’t need to become ultra rich in your lifetime. You have your lifestyle
and you just need the ability to fund it. In this case, a 60/40 or even 40/60 stock to bond ratio
might be a good option. You can taper your bond up or down based on how conservative you are.
Now, given what I just went over, I do want to say that you shouldn’t get too fixated on exact
percentage. Ten percent more or less of an asset class shouldn’t make a significant difference
in your portfolio performance. Investing and asset allocation, despite what some may say,
is actually soft science. Unlike a hard science experiment, past performance will not repeat
itself exactly in the future when it comes to investing. So understand your risk tolerance and
select an appropriate asset allocation. And know that you can always change it. I like to believe
that risk tolerance isn’t fixed because it's like a muscle you can develop. You might be more
conservative right now because your understanding of the market and your experience with it is
limited. However, with time and experience, you might be more comfortable being moderate or
aggressive. Now, if all this risk tolerance and asset allocation talk gives you a headache and
you want the simplest solution possible, I would actually recommend checking out what’s called the
target date fund. Where all this is done for you automatically based on your estimated retirement
year. I have a whole video where I deep dive into it here so check it out to see if its something
that might be right for you. Thank you guys for watching, and until next time. All the best.