Risk, Like Beauty, Is In the Eye of the Beholder: How to assess your own risk level

By Tim McCarthy

It always has amazed me how differently people think about what is risky vs. what is safe. Some international investors find currency trading not so risky; yet feel that stocks are too risky to invest in. Some Americans think even the higher quality Growth Countries are too risky to consider and believe it is safer to concentrate all their investments in the US.

Similar parochial views have been expressed to me by investors all over the world. I remember a Malaysian investor once saying to me, “I can’t risk investing in those giant American companies like GE or Microsoft. They are so far away. Whereas there’s one public company I drive by every morning on the way to work to Kuala Lumpur. They make great products and I know them well. That is a safer investment for me.”

How the Financial Services industry asks their customers about risk can confuse them even more. For instance, when customers are asked, “What level of risk can you accept? Personal risk assessment is so subjective and often, the average person doesn’t even know how to approach the question. Yet, financial advisors, brokers, and bankers all are required by the regulators to ask this question and use the answer to place people into a particular category band.

Over the years I have often heard people respond by saying,

“Well, I don’t know. I can’t afford to lose any of my money, even for a year. I worked too hard for it.”

“I want a high growth investment so long as it is going up. I don’t want anything that goes down.”

“I am a very conservative person. I don’t like to gamble. So, I only want safe investments.”

But the problem today is that if you only want investments that have no chance of falling in any given year, it means you won’t make any money as the risk free interest rate is near zero when inflation is considered. How can you grow your money over your lifetime so by the time you retire, you will have enough to live off of?

The reality for many is that asking them how much risk they would like to tolerate does not necessarily help them in the end. In fact, it can lead to an inappropriately over conservative portfolio.
As the wisest of advisors know, rather than asking a person what they think their risk tolerance is, it is better to start with what the investor is trying to accomplish. Then, through a series of questions, the advisor can come up with a recommendation as to the appropriate risk level should be for what they can realistically accomplish over their lifetime.

But why do you have to have any volatility in your portfolio?

It turns out that whenever you buy any no risk financial instrument, open a bank account, or buy a guarantee product of some kind, you are implicitly paying an “insurance penalty” to the entity that is absorbing the risk of no fluctuation in any given year. In the case of a bank, they assume the risk and they charge you for it by paying you a lot less interest than they earn. And when you buy a Treasury note or bond, the government is absorbing your risk so they also pay you less interest. It is the same with an insurance company that sells you a guaranteed product. Because you want fluctuation, it will cost you at least 1.5 to 2.0 percent a year in decreased interest earnings. That is why you need to put products that fluctuate into your portfolio, if you expect your investment portfolio over your lifetime to grow at a rate greater than inflation.

But how can you do that safely?
There is a relatively simple way to grow your money greater than the low savings rate, but with much less risk than trading. You need to follow three key rules:

Make sure you have broad diversification in your portfolio

It turns out that over time, different classes of investments or asset types fluctuate differently over time. By asset classes, I mean a broad mixture of equities, small and large, international and domestic, corporate and government bonds, and other assets such as Real Estate Investment Trusts (REITS) and even a small amount of a variety of commodities. Some classes and countries will go up in certain years while others go down. And even in a crisis where it looks like everything is falling, history as shown that some asset classes drop a lot less than others. And certain classes come back much quicker than others. Thus, there is much safety that comes from using funds to mix a lot of different asset classes in your portfolio albeit with taking much care to review each individual fund.

Use the magic of time to decrease your risk

Many people think that if they invest it all at once into the market, they could make the mistake of buying just before the markets drop. And they are right. So, how do you take away that timing risk? You just “Trickle in” a little money each year into your investment portfolio spreading it across all the different asset classes. That way, because you are spreading your purchasing over a period of a decade or more, you will have bought a little in all environments, both during cheap times and expensive times. Your average purchase price will by definition, be much lower than whatever the peak time turns out to be. The key is never put too much additional money into the markets at any one time, and never stop investing, even when you think the markets may be too high.

Leave it alone

One of the biggest mistakes people make is they pull out their money when they get nervous. Even with the professional investors that try to time markets, they are often out of the market at the right time, but seldom get back in in time. Why is that? Because the “Bulls Always Surprise You.” Consistently, people wait to get in the market until they are sure it is going up. But by then, it has already moved up. Sir John Templeton, one of the wisest investors of all time, said it best, “If you see light at the end of the tunnel, it is already too late.” So, treat your investment portfolio allocation like a good scotch or a fine Bordeaux wine. Leave it alone. And after you retire, only take out each year what you need to live off of.
If you follow these three rules, you will minimize your risk over the life of your portfolio while maximizing your return.

Okay. But exactly how do I set my risk level in putting together a portfolio? How much volatility can I risk?

The ideal risk profile of your overall portfolio is a function of a few critical facts about your personal life:

Have you already put aside in your Savings Pocket enough money for emergencies?

How much is enough in this Pocket? It is best to have about six months of expenses set aside that is in a no risk savings account or money market, so it is also very liquid, i.e. you can get it out any day. After that, leaving too much money in this Savings Pocket means you won’t get any growth. And worse, you will fall behind if there is any inflation. For some, if they are worried about losing their job, or they have big expenses coming up soon, they made need more in their no risk Savings Pocket, but for most people, once you have set aside your emergency money, the rest can then go into growing your money.

How assured do you feel you will continue to make money in your job?

And how many years is it before you stop earning a salary? These are more important questions than simply how old you are. After all, if you are healthy and feel you can stay on the job, even if you are over 60, you may have an income profile that looks more like a 50 year old. The more years you are going to continue to work and the more assured you are of keeping your job, the more volatility you can afford to take. It is the more volatile asset classes that long term often give you the highest long term return. But it means that you need to stay invested for a decade or more in these more volatile asset classes to reap the benefit.

Before you retire, do you have any intermediate term needs for cash?

For instance, if you have children, will you need to pay for their college education in five or ten years? If so, the risk level of this shorter term separate portfolio should have a higher portion of lower volatility assets like medium term highly rated bonds and a small portion of lower risk stocks. However, you should make sure that your long term retirement portfolio that you are building up for your own retirement years is fully invested in the more volatile or risk oriented assets.

What are your other assets?

If you have considerable equity in your house or other assets outside of your investment portfolio, then you can afford to have more volatility, ergo more chances for long term growth in your investment portfolio.

What do you think you will spend in your retirement years?

Most people think they are going to probably live as long as the average life expectancy. But what is often overlooked is the concept of conditional or given probability. This means given that you and your spouse are for instance, already over 50 years old, and in good health, then your personal life expectancy is much longer than the average person. It is also important to remember that your money has to last as long as you both live. Even if one of you passes away in your 80s, the other one may live into their nineties, and you don’t want your money to run out six months before you both pass on. Thus, you have to make sure your money lasts much longer than you think you personally will live. Even after you retire, your money needs to keep growing for as much as 30 more years. Thus, you will need to keep a good portion of your portfolio in risk growth assets such as equities.

It is only after you answer the above five questions, can you and your advisor then decide what is the appropriate level of risk you should build into your investment portfolio.

Since people often like to see an example, below is a simple case where a husband and wife are both 60, have no more extraordinary expenses coming up and both plan to work another 5 years. At that point, their house will be fully paid off and they can live on less than when they were raising their children.

They need their money to keep growing after they retire, but do not want any chance long term of losing their nest egg. Here is a sample of what their portfolio allocation ranges could look like from a risk standpoint:

• Savings portion: 15-20%
• Intermediate and long term bonds 20-40%
• Equities
• Domestic 15-35%
• International 10-20% Other: REITs, commodities, etc. 5-15%

A couple of quick comments:

1. Note that even if you pick the maximum percentage for Savings, you still are going to have to invest more than the minimum range in the higher volatility category of equities. Otherwise, you money just won’t grow enough over the coming decades.
2. Some of you may be afraid of international, even the better quality Growth Countries. Yet it is actually too much risk to only invest in the aging countries. After all, by the end of this decade, nearly half of all wealth and income and production will come from outside of the US and Europe. So, a broad based portfolio mixing in these Growth Countries is wise.

Tim McCarthy is the author of The Safe Investor : How to Make Your Money Grow in a Volatile Global Economy (Feb 2014; Published by Palgrave Macmillan). For more information please visit timmccarthy.com, and follow the author on Facebook and Twitter.