How much risk is right?
Build a portfolio that doesn’t keep you up at night—while achieving your goals
By James Parkyn - PWL Capital - Montreal
After three straight years of double-digit equity gains, it’s easy for investors to feel bullet-proof. Yet history reminds us that market corrections are inevitable.
Times of euphoria are a good time to ask ourselves: How much of a drawdown could I truly tolerate? If you don’t think about this now, you’re more likely when a correction hits to make emotional decisions that undermine your investing success.
3 pillars of risk profiling
At PWL Capital, we determine our clients’ risk profile as an important step of creating their investment plan. The process includes filling out a risk profile questionnaire. We’ve now made it available on our website (try it here).
The questionnaire helps determine three important things about an investor:
Their financial ability to take risks
Their psychological ability to tolerate losses
Their need for risk
Financial ability to take risks
When designing an investment plan, it’s important to assess a client’s financial capacity to handle risk. This breaks down into a few elements.
Time horizon—The longer you have, the more time there is to recover from inevitable down markets. Time horizon influences the portfolio’s allocation of stocks versus bonds—with the latter acting as a stabilizer or safe bucket. It’s worth noting that retirees can have very long time horizons of over 20 years.
Value of your human capital—This is the investor’s lifetime capacity to earn income from work, save and build a retirement nest egg. Some have very stable cash flows; others less so. Some investors maintain the value of their human capital past retirement age, continuing to earn employment income.
Risk capacity—To evaluate risk capacity, we prepare a detailed balance sheet for the client. A personal balance sheet is like getting a blood test at a medical checkup. It gives important insights for understanding an investor’s financial health and capacity to withstand large drawdowns.
Psychological profile to tolerate losses
Using the risk profiling questionnaire, we also assess the client’s emotional comfort with volatility and seeing losses in their portfolio. There’s an old saying: “An investor really learns their true risk tolerance in bear markets.”
Loss tolerance is important for designing a portfolio that the client can comfortably stick with for the long term. If an investor panics and sells in a bear market, they’re at serious risk of reducing long-term returns while they wait on the sidelines. As we often say, timing the market is virtually impossible.
Thinking about loss tolerance is especially important today after the exceptional stock markets of the last three years. It’s useful to keep in mind that markets don’t just go up. Global stocks experienced six bear markets (a 20%+ decline after inflation) in the past 55 years. That works out to 1.1 such declines per decade on average.
If you fear you may panic and sell, then you should reconsider the balance of stocks versus bonds in your portfolio.
During annual review meetings, we show clients our model portfolios and the returns pre-fees over the last 20 years. The worst period was March 2008 to February 2009. A balanced account (60% stocks, 40% bonds) dropped about 20%, while an assertive portfolio (80% stocks, 20% bonds) fell about 27%.
Despite these losses, a balanced account had a 6.73% annualized return over the past 20 years. An investor who held the entire time would have seen their holdings multiply by 3.68 times. An assertive portfolio saw an annualized return of 7.93%, with their holdings increasing by 4.6 times.
Need to take risk
Finally, we evaluate the client’s investment goals and balance sheet. If your assets are limited, you may need to take on more risk to achieve your financial goals. On the other hand, a multimillionaire who lives on $50,000 annually doesn’t need to take on undue risk.
We do financial planning with clients to understand their needs. For accumulators, we estimate the savings they require. For retirees, we aim to find a sustainable withdrawal rate.
We also consider expected returns on investments and inflation. (You can find our latest twice-yearly report on estimated expected returns in podcast #79 and this blog.)
How aging alters perception of risk
New research says we must also take into account aging. Brain systems for learning, reward and risk assessment evolve over a person’s life, says University of North Carolina finance professor Camelia Kuhnen in a recent research paper. “Those changes systematically affect financial behavior.”
Each person is different and some are unaffected. However, Kuhnen says, aging can reduce the brain’s ability to learn from experience. This is especially true in uncertain situations—such as the environment investors face.
“When decisions depend on tracking outcomes over time—such as figuring out which investments are paying off—performance declines,” Kuhnen says.
This doesn’t mean aging degrades financial decision-making. Rather, we must consider that older people may learn differently and respond differently to information.
At the same time, older adults often outperform younger ones in some areas: managing emotions and maintaining discipline during stressful times. They’ve lived through so many bear markets that they learn to tune out the noise. All this goes into helping to prepare a client’s investment plan.
Risk you can live with—and profit from
Past experience with downturns teaches us important lessons. Markets have prospered despite the dot.com crash, 911, the 2008-09 financial crisis and Covid. The key to navigating these periods is to have a long-term investing plan that reflects your risk profile and sticking to it with discipline.
As David Booth of Dimensional Fund Advisors put it: “Since we know risk is unavoidable—and it’s the source of investment returns—you want to find the amount of risk that is right for you.”
Well said, David. A patient long-term approach converts risk into gain.
Find more commentary on personal finance and investing, our podcast, past blog posts, eBooks, model portfolios and market statistics on the website of PWL Capital’s Parkyn-Doyon La Rochelle team and our Capital Topics website.