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Risk Tolerance is Relative

By: Robert Gordon

By: Robert Gordon, MBA, CFP®, AIFA®

It is as predictable as the rising or setting of the sun, investors buy when the market is making new highs and sell when the market is making new lows. This buy high, sell low behavior robs them of their share of capital market returns. Investment advisors and the academic community frequently discuss the importance of understanding a client’s risk tolerance. Much energy has been expended in the creation of fancy questionnaires and other tools which are used to gain some understanding of an investor’s appetite for risk. Like many questions in the realm of investor psychology and behavior, there are no hard and fast rules but investors can benefit from some attempt at measuring their tolerance for risk albeit flawed.

Criticsof the measurement of risk tolerance maintain, “How can a questionnaire accurately simulate an individual’s reaction to a market decline?” or “Investor sentiments are so variable it is impossible to accurately measure them?” They may be right. Investors, like all people, have a natural aversion to making decisions they will regret. Cumulative Prospect Theory, developed by Daniel Kahneman and Amos Tversky in 1992, attempts to explain, in an academically rigorous fashion, the notion that individuals when faced with risky prospects do not make decisions consistent with maximizing their benefits. Among other findings, their work confirms what everyone has always surmised; people tend to overweight extreme and therefore low probability events when considering future outcomes. It also confirmed a finding that was explicitly stated by Markowitz in his groundbreaking work which is that investors are risk averse or more concerned about losses than they are gains. Given these findings, one would assume that the task of creating tools to accurately measure risk tolerance would be easy. That is far from the case.

Measuring risk tolerance is essential to managing expectations both for the advisor and the investor. That risk tolerance is also affected by non-emotional factors such as time. An investor may desire a portfolio that has a high standard deviation but if that investor needs to begin withdrawing money from his portfolio at a very high rate, the volatility of an aggressive portfolio would be deadly to the portfolio’s longevity. As an example, let’s look at two portfolios both with an initial withdrawal of $40,000 and increasing by the inflation rate:

$40,000 initial withdrawal with an annual 3% Cost of Living Adjustment
Allocation Model Annualized Return Standard Deviation 40 Year Probability of Zero Value
60/40 9.68% 11.98 9%
40/60 9.37% 9.89 6%

*Time period is January 1979 through June 2009. Equity portions are split equally between the S&P 500 Index and the MSCI EAFE Index. The fixed income portion is the Barclays US Aggregate. Monte Carlo simulation was used to generate the 40 year probability of zero value. Inputs were 40 years to simulate, 10,000 trials and inflation rate of 3%.

As shown the probability of zero value, while still relatively low, is 50% greater in the model with the higher equity percentage. If the withdrawal rate increases by 1%, the results are as shown below:

$50,000 initial withdrawal with an annual 3% Cost of Living Adjustment
Allocation Model Annualized Return Standard Deviation 40 Year Probability of Zero Value
60/40 9.68% 11.98 13%
40/60 9.37% 9.89 7%

*Time period is January 1979 through June 2009. Equity portions are split equally between the S&P 500 Index and the MSCI EAFE Index. The fixed income portion is the Barclays US Aggregate. Monte Carlo simulation was used to generate the 40 year probability of zero value. Inputs were 40 years to simulate, 10,000 trials and inflation rate of 3%.

That relatively small increase in withdrawal rate dramatically increased the probability of achieving a zero value. The reason is the higher volatility primarily in the equity portfolio. The message is, reaching for the small amount of additional return does not pay off especially when withdrawal rates are relatively high.

Ultimately, the question of risk tolerance can only be answered through a comprehensive review of the investor’s financial situation. Risk management tools such as long term care insurance, longer working lives and other factors will significantly affect the client’s ultimate decision regarding asset allocation and portfolio construction. Establishing an understanding regarding risk tolerance is important and, if nothing else, allows the investor to have some idea, albeit rough, regarding the decision he or she is making.