Perspectives from the Latest Market Decline -- Client Corner

Perspectives from the Latest Market Decline by Scott Darling

‍

‍

How do you decide how much risk to take with your investments? Are you a risk-taker or risk-averse?  Does that change with time?  How should your individual risk tolerance influence your investment allocations?  These are all questions I have thought deeply about throughout my 35 years of investing. I’ve always felt that I had a higher risk appetite than the average investor.  And that bears out through my results from free psychometric assessments that are available online to help predict your loss tolerance (https://static.arnaudsylvain.fr/2017/03/The-Grable-and-Lytton-risk-tolerance-scale-15-year-retrospective.pdf).  In fact, I score in the top decile of risk tolerance– it’s neither good or bad - it’s just me. But this year’s sharp 22% decline in the US stock market, as represented by the S&P500, made me re-consider what I thought I knew about my own risk tolerance.  During the April lows I certainly thought the markets could go much, much lower and, even though I had significant cash on the sidelines that I could have invested, I stayed put.  Perhaps it was fear or perhaps it was greed.  But, for sure, one thing had changed from all the other declines I had experienced – I am now retired. Not only do I have more invested than ever before, I also no longer have a reliable income to count on when the markets go down. Frankly, in April I felt more exposed than I had ever felt before.

So how can we better understand our risk tolerance? John Grable’s 1999 framework is a useful place to start.  Grable identifies three factors that in combination determine an individual’s risk profile.  

1. ‍Your behavioral loss tolerance: Subjectively are you comfortable with losses? Proverbially, can you sleep at night?‍
2. Your ability to take risk: Your capacity to hold a risky asset without having to sell to fund your life and without compromising your lifestyle.‍
3. Your need to take risk: What is required(or not required) to meet your financial goals. Someone who is very wealthy may not need to take more risk but they may have a very high capacity for risk.  It’s helpful to frame need in the context of your life’s financial objectives.

I’ll focus on the behavioral loss tolerance because it is the key constraint on asset allocation.  No matter what the science and models say, the factors that determine whether you can live with your investments usually determine your ultimate allocation decision over time, regardless of your ability to take risk or your need. Loss tolerance roots out the gap between theory and practice.  And, in fact, most people are more risk averse in practice than they think they are in the abstract.

Grable identifies six factors that contribute to behavioral loss tolerance, which are generally more psychological than physical:

a. Risk tolerance - your willingness to invest when there is material potential for gain AND loss;

b. Risk preference - your general desire to take more or less risk;

c. Financial knowledge - your education and training – more financially literate people are typically more accepting of risk;

d. Investing experience – your market participation as distinct from knowledge – unless you’ve truly lost a big chunk of money you probably don’t know how you will behave in the moment;

e. Risk perception - your subjective assessment of risk - do you perceive markets to be riskier or less risky than they really are?; and,  

f. Risk composure - your behavior during difficult market conditions.  Can you have as planned when it gets tough?  To truly know this, you must have lived through a material crash or two when it mattered.

My Discoveries from the Last Crash

‍

‍

I’ve already highlighted that I am relatively risk tolerant.  I’m on the right side of the normal curve that defines the population’s aggregate risk tolerance. I’ve also gained and lost a fair bit of money over 35 years, so my risk preference is reasonably balanced. That has resulted in an investment portfolio that has been well-diversified across stocks and bonds so far.  In the future I expect to increase risk during retirement, something called a“reverse-glide path” allocation strategy (but we’ll save that topic for another day).  My career focused on energy finance, and I consider investing to be a hobby that I like to study.  Because of my background I have a good academic and practical understanding of risk, and I have survived at least six material market crashes.  That’s my assessment.  I think it would be good for investors to honestly assess their own risk tolerance based on the factors described above.

I had three take-aways from April’s decline, which I’m trying not to forget now that the market has recovered.  

• There’s a tremendous difference in risk perception when you experience a significant and quick drawdown in your wealth when you are working and have an income versus when you are retired and have less or little ability to replenish.  I was fully prepared to invest available cash in the market but I either lost my nerve (fear) or wanted even more (greed). So even though I had prepared for that eventuality, I stood pat.  On the positives, I didn’t sell in a panic even though the amount of money I had lost was material and made me a little sick.  On the negative, I had an investment plan, but I didn’t entirely stick to it.  The lesson? Work with your advisor to develop a robust plan that you can tolerate and use them to help you execute on that plan.      

‍

• As you discover your risk tolerance you can make mistakes early when you’re younger, when you don’t have as much money at risk, have time on your side and have years of income before you.  You can afford to misjudge your risk tolerance when you’re young.  Getting it wrong when you are older can be much more damaging because you can’t afford to find out you can’t stomach a loss in the moment.  In fact, now that I am older I wish I had taken more risk by allocating more money to riskier equities instead of bonds.  This is not back casting now that I know the outcome. I had stable employment, a good career trajectory and a pension.  Looking back there were no years when I had a net reduction in my investments even with many market declines.  Human capital is perhaps your largest asset and it has many characteristics of a bond, though not in all cases.  I had the ability to take more risk, but I followed a more generic path that wasn’t best suited for me.  That is something for younger investors to fulsomely consider with their financial advisors.

• It’s very easy to be more risk-seeking now that the market has recovered.  Don’t fall for that trap.  Don’t make major philosophical changes in your portfolio because you’re feeling good about your risk tolerance at market highs.  Studies show that an investor’s risk tolerance rarely changes over time, even in retirement.  It is part of our nature as humans.  So thoughtfully consider what you think you should do.  Work with your advisor to craft the plan.  But wait to make those decisions at market lows to see how you really feel in the moment.  Perhaps, instead of taking more risk when the market is making new highs, you’ll discover that you don’t have the tolerance for that volatility at the lows. Either way, set your long-term allocation, remember how you felt at the lows and don’t go changing it back when the market recovers!    

They say shared experiences are a valuable learning tool.  I hope you’ve enjoyed mine.  I hope to contribute to this blog for Brownlee Wealth Management monthly (or for as long as they’ll let me 😊).  Next month I plan to talk about my experience with buying and owning a second home.  While none of this should be taken as investment advice, if you have feedback or comments please feel free to share with it Justin and the team or write me directly at scdarling@sbcglobal.net.

‍