4.3 Risk tolerance
In earlier articles I discussed how making riskier investments can cause emotional turmoil that clouds investing decisions. In this article I dive a little deeper into the concepts of investing risk and risk tolerance from a mindful perspective.
To understand the concept of “risk tolerance”, we first need a working definition of investing “risk”. At the simplest level, investing risk is the future potential for investments to decline in value instead of growing in value. The risk becomes an actual hazard if you have to cash in your investments at these inopportune times, such that a permanent loss occurs. Some people define this more specifically as the potential for investment declines or permanent losses such that your overall investing plan, like your retirement goal, is jeopardized. The level of risk is a factor of the size of the potential decline (how much money you could lose) and the frequency or chance of the decline (how likely it is that the decline will happen in a given period). Risk is also sometimes defined as a missed opportunity to make money in some other investment, but that is a type of opportunity cost that we won’t address in detail here. Finally, risk is loosely applied by some to known continual processes, like “risk of inflation”. But as discussed in Article 8.6, such continual processes are more efficiently addressed as underlying assumptions of an analysis.
There is a fundamental link between risk and investment performance or return that often goes unexplained. The investments that have the potential to grow the fastest are also the investments that have the highest risk of declines. Stocks are generally considered a somewhat risky investment, because stocks are subject to periodic temporary declines, sometimes of considerable size as detailed in Article 4.2. That article also notes that viewing stocks simply as risky is misleading, because past stock performance over long periods suggests declines in stock values are temporary aberrations. This graph summarizes the relationship between investment risk and return for various investment types.
This graph is only a conceptual example. If you plotted the actual returns and actual estimated risks for each of these investment types based on historical data, you’d be unlikely to get such a perfect linear relationship. There is also disagreement with the exact order of the relative risk and returns of these investment types. So, you may find similar graphs order these investment types slightly differently. Also, some types of investments are not shown in this example, such as insured certificates of deposits, which have low risk and return, and corporate bonds, which have higher risk and return. Regardless, the example graph is not a recommended investing tool. It simply illustrates that under most circumstances, as the potential return increases, the risk also increases.
Looking more closely at some of these investment types, if you invest in things like U.S. treasury bills, you are very unlikely to lose your money over the life of the investment. Because a U.S. treasury bill or U.S. government bond is essentially a loan you make to the government, the government would have to default on those bills or bonds for you to not get your money back plus interest, which is a pretty unlikely outcome. Accordingly, government bills and bonds generally pay a relatively low interest rate to the investor. That is, they have a low return. On the other end of the spectrum are things like commodities (including precious metals), prices of which are relatively volatile and subject to all sorts of unpredictable market forces. At times, the prices of commodities can sky-rocket, greatly outperforming other investment types over relatively short periods. Article 6 provides more details on the various types of investments that are likely options for the small retail investor.
The notion of risk tolerance
There has been a lot written about “risk tolerance”. The basic concept is that you should balance your investments, selecting some relatively risky and some relatively safe investments, such that you expect to achieve your desired total account value at some point in the future without taking on more risk than you can tolerate.
But what does “tolerate” mean in this case? There are generally three kinds tolerance discussed:
- Investing time horizon
- Willingness to take on risk
- Ability to take on risk
Let’s un-package each of these and see what’s actually at the bottom of this risk tolerance concept.
Time horizon – Conventional wisdom says that if you have a long time before you need to use your money, you can take on more investment risk in the interim. So, if you are 30 years from retirement, you can put your money in more risky and higher return investments. This allows time for your investments to recover if a temporary decline occurs. From a mindful perspective, this time horizon concept is not clearly related to risk. As we noted above, we define risk as the size of the potential decline and the frequency of such declines. Frequency is just the chance of a decline over time, such as an average of one decline every 5 years. By looking at time horizon as part of risk tolerance, time confusingly becomes part of both the risk and your tolerance of the risk. Following this approach for a relatively risky investment, which has substantial declines often, you should be willing to endure more of those declines the longer you are willing to invest. That may be true for some people, but might be exactly the opposite for other people.
In fact, as the number of substantial declines experienced increases, some investors will abandon the investment before achieving the expected long-term returns. See the “panic selling” discussion in Article 4.1 for one example. For another example, participation in the stock market by individual investors has nearly halved from 30 percent to 16 percent in recent years. The market participation levels in 2014 hit a low that had not been seen since 1962, although there is recent evidence that small investors are coming back to the market. This historic retreat from the stock market is largely attributed to the effects of the large market declines of 2000 and 2008. Clearly, many people with long investing horizons were not able to endure those repeated stock market declines, which is exactly the opposite of the time horizon assumption.
Put another way, with time horizon as a part of risk tolerance, if you have a nearly infinite time horizon, you should be willing to take on nearly infinite risk. Nearly infinite risk means that there is a near 100% probability (declines occur very often) that you will lose most of your money (the size of decline is large). Following such logic, if you are 18 years old and saving for retirement at age 75, you should go to Las Vegas and try to hit a jackpot. However, the most likely result is that you would instead gamble away all your money and have nothing left to invest.
No one really wants to invest on that basis. The authors of “Risk Less and Prosper” share that view. The book notes,
- “If an individual has a long time horizon, it is taken as an indicator of tolerance for risk. The possibility of having a long time horizon and yet being extremely averse to risk is ruled out.”
Consequently, we address investing horizon, or time, from a mindful perspective in a separate discussion in Article 8.
Willingness to take on risk – Willingness to take on risk is a subjective measure of your ability to overcome worries (your fears) about potential future declines and invest anyway. Fear is one of the primary emotions of investing as discussed in Article 4.1. The flip side of willingness to take on risk is “loss aversion”, or how averse you are to losing a substantial chunk of your money. Again, “aversion” is just another word describing your emotional reaction to a loss.
If we ignore the time horizon concept for reasons discussed above, then risk tolerance is mostly about emotions. This is clear when we look at how investment advisors typically measure their client’s risk tolerance. Many advisers will ask you to take a questionnaire about your willingness to take on risk such as this one. If we ignore the time horizon questions, these questionnaires show the emotional nature of risk tolerance. Here are some examples of questions from real questionnaires available on the web, with my emphasis added to the words and concepts that are code for emotions:
- Which of these statements best describe your attitudes about investment performance in the next three years? Example answers include: “I can tolerate a loss” and “I have a hard time tolerating any losses.”
- Which of these statements best describe your attitudes about investment performance in the next three months? Example answers include: “I wouldn’t worry about losses in that time frame” and “I’d have a hard time accepting any losses.”
- In terms of experience, how comfortable are you investing in stocks and stock mutual funds?
- When you think of the word “risk”, which of the following words comes to mind? The answer options are “Loss”, “Uncertainty”, “Opportunity”, and “Thrill”.
- Would you prefer a $200 gain best case/$0 loss worst case or a $4,800 gain best case/$2,400 loss worst case?
- If you had to invest $20,000, which of the following investment choices would you find most appealing?
- How would your best friend describe you as a risk taker? The answer options are, “A real gambler”, “Willing to take on risks after completing adequate research”, “Cautious”, and “Real risk avoider”.
- Do you generally prefer investments with little or no fluctuation in value and are willing to accept the lower return associated with these investments?
- When you invest money are you most concerned about the investment losing value, gaining value, or equally concerned about it gaining or losing value?
Criticism of such questionnaires notes that risk tolerance is a “psychological trait”, which is another way of saying that the concept is all about emotions. These criticisms include that investors fill out questionnaires in a rational state and react to actual investment losses in an emotional state. Saying, “Yes, I can withstand a 25% drop in my portfolio value”, is fundamentally different from actually withstanding a 25% drop in a portfolio and taking no action. Investors are using two different brain systems at these two different times with sometimes radically different outcomes. These two brain systems were popularized by Nobel laureate Daniel Kahneman in his book Thinking Fast and Slow, which is based on extensive research by him, Amos Teversky and many others. System 2 tends to be rationale, methodical, and conscious (filling out a questionnaire), while System 1 tends be emotional, quick, and mostly subconscious (reacting to a market plunge).
Ability to take on risk – The ability to take on risk is also called “risk capacity”. Risk capacity compares how much money (or other assets) you have to how much you might lose through investing. The idea is that if you are risking a small percentage of your assets, you should be able to lose most or all of that investment. Although we already have a bewildering array of terms related to risk tolerance, some researchers define risk capacity as an “objective risk”, whereas willingness to take on risk is a “subjective risk”. Objectively speaking, you should be more able to lose 10% of your assets than 50% of your assets.
While that intuitively makes sense, every investor would clearly not react the same way to losing a given percent of their assets. For example, someone who is extremely unwilling to lose money may be alarmed by losing 10% of their total assets, while another person who is very willing to take on risk may be unconcerned by a 10% loss. Although the concept of risk capacity is objective, in actual practice, it is still linked to the investor’s real world subjective judgments and emotions about investment losses. The book “Risk Less and Prosper” notes,
- “Your ability to take risk is entirely different from how you feel about risk…Risk capacity is an objective measure that reflects how much money you can afford to lose, even in a worst case, without impairing your minimal goals. But how you feel about risk is subjective.”
So, the heart of risk tolerance is still our subjective “willingness” or our emotional ability to take on the risk, even if that risk is objectively small. The book “Risk Less and Prosper” has some very useful concepts about investing risk. However, I should note that the book’s conclusions that we should avoid objective risk as much as possible and focus on the safest possible investments are at odds with a mindful investing approach. We address this issue in more detail in later articles.
Mindfulness and risk tolerance
As we have seen, risk tolerance is defined in numerously overlapping and confusing ways, but it mostly boils down to our subjective emotions about losses. Stripped of its “time horizon” and “risk capacity” disguises, risk tolerance is almost entirely about our own specific emotions and how we handle them. This is fertile ground for a mindful approach. As described in Article 4.2, a mindful investor will worry less about the potential for future investment declines and will remain relatively calm even when very large declines occur. This in turn helps the mindful investor continue with long-term investing plans and avoid emotionally driven decisions like panic selling.
Returning to the fear and greed dichotomy discussed in Article 4.1, we can see that the concept of risk tolerance as an investing tool is driven mostly by fear. Or more precisely, investing decisions based on risk tolerance subjugate us to our worries and attempt to avoid fearful situations in the future. Because mindful investing shuns fear, or other emotions, as decision criteria, we can ignore most of the advice that comes from the notion of risk tolerance. Trying to avoid fear by gauging your “tolerance” to risks is not a rational way to invest. This is particularly true because you are likely to use a rational brain system to gauge your tolerance, but you may feel compelled by an emotional and subconscious brain system when it comes time to make a real world decision.
For example, investing and finance companies invented so-called “low volatility funds” within the last ten years, and these funds have become popular. Volatility refers to the routine variability (the ups and downs) of an investment’s value over time. Low volatility funds seek to achieve the overall performance of some basket of stocks, like an index, but with lower variability over time. These funds try to moderate the typical investment ups and downs and the resulting fearful reactions of investors. This graph compares the price performance of the oldest low volatility exchange traded fund (ETF), with the ticker symbol SPLV, to the S&P 500 index.
Given that SPLV has only been in existence since about 2011, and this has been a period of unrelenting stock market increases, it’s hard to discern the lower volatility of this fund. A very close examination of the graph reveals that SPLV was usually a little less volatile than the index.
Volatility is often measured by “beta”, which compares the volatility of the stock or ETF in question to its most relevant index, in this case the S&P 500. A lower beta value means lower volatility. SPLV has a beta of 0.65 in the last three years, which is a little below the beta of 1 for the index. Put another way, the “low volatility” SPLV still experienced about 65% of the volatility of the index. Worse yet, when steep declines did occur, such as in 2015, SPLV sometimes had temporary declines that were almost identical to the index. Retail investors are flocking to these low volatility funds to quell their fears of investing losses, even though they are getting a pretty minimal decrease in actual volatility.
For a mindful investor, “risk capacity” is probably the only useful concept from the world of risk tolerance. A mindful approach is grounded in objectivity and reality, and “risk capacity” is an objective measure of your potential losses as compared to your total assets. Thus, it appears rationale to use this objective comparison when selecting investment options. We come back to this concept in Article 8. But before we go there, Article 5 on “Beating the market” explores another common emotional pitfall of investing.