Risk Tolerance Verus Risk Appetite
Key Takeaways
- Many investors are surprised to learn what their actual risk tolerance is.
- Investing more conservatively as you approach retirement makes sense on paper—just understand the pros and cons of this method to “sleep better at night.”
- The next decade may not look like the last decade in terms of market performance.
When markets soared in 2019, most investors wished they had taken on more risk. But those are the same investors who wish they had been more conservative when the markets fluctuated wildly and trended downward during the pandemic onset.
Hindsight is always 20/20. But, if you are willing to take a step back and look at history objectively, you will see the incredible growth opportunities for those who invest and stay invested in the global stock markets. Below is one of my favorite charts displaying the growth of a hypothetical $1 invested in different types of portfolios from 1985 through the end of 2019. Data is from Dimensional Fund Advisors’ (DFA) globally diversified Dimensional Core Wealth Index Models.
* Source: Dimensional Fund Advisor’s Matrix Book 2020
Past performance is not a guarantee of future results. All performance results of the Dimensional Core Wealth Index Models are based on performance of indices with model/back tested asset allocations; the performance was achieved with the benefit of hindsight; it does not represent actual investment strategies. The model’s performance does not reflect advisory fees or other expenses associated with the management of an actual portfolio. There are limitations inherent in model allocations. In particular, model performance may not reflect the impact that economic and market factors may have had on the adviser’s decision making if the adviser were actually managing client money.
Balancing Risk and Return
When examining the chart above, starting with the left-hand column, you see the growth of $1 if you remained in a conservative (100% fixed income) portfolio from 1985-2019. By year-end 2019, your dollar would have grown to $6, without adding another penny to your stake. There is nothing wrong with a 6x return, especially when you are taking on minimal risk. Over the 35-year period, you can see that your worst year return would have only been -3.48% and your average annual return would have been +5.32%.
As you scroll across the chart from left to right, each column represents an increasingly risky portfolio mix, culminating with the highly aggressive (100% equity) portfolio on the far right. If you went all-in for this exercise and put your $1 into the highly aggressive (i.e., 100% equity) portfolio, you would have ended up with $41.98. That is not a typo—you would have earned 42x your money over 35 years, an average annual return of almost 11.5%!
Why wouldn’t you choose the highly aggressive investing option to begin with? For starters, you would have had to endure some stomach-churning roller coaster rides, including the loss of almost half your money (47%) during the 2008-09 financial crisis and then taking another significant hit during the spring of 2020 when the pandemic began. If you are just beginning to save for retirement, there is plenty of time to recoup those painful losses. However, if you are retired, or just a few years from retirement, your portfolio may not be able to handle those hits.
Finding your Sweet Spot
Our clients are sensible people with realistic expectations of future market returns. Most have an allocation ranging from semi-conservative (40% equity/60% fixed income) to aggressive (80% equities/20% fixed income). The biggest takeaway from comparing these two allocations is the incredible growth we have seen in the past by participating in the stock market at any level. Even after enduring a -40.31% hit in 2008-09 and several other 20% drawdowns, the 80/20 portfolio in the chart above still had an ending value that was almost double the semi-conservative (40/60) portfolio over the 35-year period.
Now that we can see what was possible over the last 35 years, we can ask ourselves, “Would I have had the stomach to stick through the volatility, the uncertainty, and panic of 2001 and 2008, much less the COVID-19 pandemic?” If we are honest with ourselves, the answer is “probably not.” Some of you would have taken a portion of your money “off the table” when the economy was rocky or jumped into a hot stock your neighbor or golfing buddy recommended. It is very difficult to stay the course over 35 years. This dilemma is often referred to as risk tolerance versus risk appetite. An objective third-party, such as your financial advisor, can help you balance this risk versus appetite dilemma.
By the way, an investor’s risk appetite is not always higher than their risk tolerance. In some situations, an investor is unaware of the underlying risks in their portfolio. For instance, he or she may be invested in 100% bonds. This sounds conservative, but if those bonds are all high-yield “junk bonds,” it is actually a risky portfolio. Similarly, they may be invested in 50% stocks and 50% cash, but if their stock portfolio is comprised entirely of one stock, they would be taking on considerably more risk.
Times to Increase Risk Exposure
Another consideration is balancing your need for risk with your tolerance for risk. If you want to retire earlier, but do not want to save more or spend less during retirement, you may need to increase your risk exposure to increase your chances of generating a higher portfolio return. I am not talking about rolling the dice with a big stake on a hot IPO. But rather, if you are normally comfortable with a 60/40 portfolio, you may need to increase that equity exposure to 80/20 and hold that position for a longer period.
Expectations Going Forward
Now more than ever, we believe that past performance is not what we expect going forward. In Vanguard’s Economic and Market Outlook 2021, they predict we should only expect U.S. equity returns between 3.7% and 5.7% for the 2020 decade. Worse, U.S. growth equities are expected to return a paltry 1.1%-3.1% per year, and U.S. aggregate bonds between 0.7% and 1.7%.
Balance is Key
The best thing you can do is align your risk tolerance and risk appetite. Remember, it’s a delicate balance that can change over time. Before making any significant moves to your portfolio allocation, talk over the pros and cons with your financial advisor. These professionals can help you stay on track and avoid costly mistakes.
If you or someone close to you has concerns about portfolio allocation or risk exposure, contact us at any time. We’re happy to help.
