Know Thyself.Module 4: Risk Appetites and Time Horizons.
Risk and reward. Can’t have one without the other, like PB&J. This is the fundamental governing principle of investing -> you can’t make more without putting more on the line.
Think of it like roulette. For some, putting a few chips on red (50/50 odds) is the right bet, while for others, putting all of your chips on lucky number 26 (35 to 1) is the only way to play. But what happens when 27 black comes up? Will the players make the same bet?
Let’s be clear, investing is not gambling. Really. It’s not. This is just a very relatable example to set the stage. Before starting the module, the main takeaways to keep in mind are the following ‘laws’ of finance and investing:
Everyone is unique. Your combination of goals, financial circumstances, age, social status, and most importantly, risk personality tell you how to invest, and which strategies to adopt.
Time neutralizes risk. The longer you can wait on an investment, the more risk you can take on.
What you will uncover in this module:
Understand your ‘investing personality’
Learn about risk, how it’s quantified, and why it matters
Learn basics on how we manage risk in portfolios
Disclosure: While we’re at it, please know that supermoment may receive compensation through partner links displayed below. But remember, this will always be at $0 to you or even at a discount, with the added bonus that a large part of any proceeds will be donated to Kiva and Accion to support entrepreneurs and promote financial equality. => open an account = fund a new business.
Intro: What is Risk?
Risk is the uncertainty of loss from an investment decision. A more technical way to phrase it would be the chance that an investment (or portfolio) generates a return lower than what is expected.
Risk is measured by calculating the standard deviation or variance of an investment’s performance. What’s that you might ask? Standard deviation tells us the volatility of a security. This is a measurement of how far up and down from the average price or average return a price moves.
For example, let’s say we have a stock XYZ with an average yearly return over the last 5 years of 10%. If the risk, or volatility, of XYZ is 5% in the same period, then we would expect about a ~70% chance that the next year return would fall in the range of 5% – 15% (add/subtract your volatility to the mean).
Ultimately this gives us a sense of how dramatic price swings are for a given asset or even portfolio. Volatility is a big reason why you want to diversify your portfolio – we don’t want everything swinging in the same direction at the same time, it’s all about smart balance.
Why do we care about risk?
Well…we want to invest AND still be able to sleep soundly at night.
I am also reminded of the Seinfeld bit on pain relief. Maximum strength. Extra strength. ‘Give me the maximum allowable human dosage…calculate what will kill me, and back it off just a little’.
Taking on investing risk is kind of the same. You want to take on as much as you can comfortably handle to maximize your returns. Obviously this is different for everyone, so determining your ‘maximum allowed dose’ of risk is why we’re here.
Going back to our roulette example, we care about risk quite a lot to be able to gauge if the upside is worthwhile. Without understanding risk, we can’t objectively understand if the reward is any good. This applies to any type of investment.
We can also use volatility as a normalizer to help us screen for stocks/funds that we want to invest. If two funds in the same category have the same average historical return, it’s wiser to choose the one with less volatility.
Perhaps the largest reason we care about risk is to simply internalize it. Every security can technically go to $0 and become worthless. You can lose everything you put in. The chance of that happening is close to 0%, but the possibility still exists and you will be a better investor with that always in mind.
What can we do to reduce risk?
Low-Risk Assets: The most basic way to reduce risk is to invest in ‘safe’ assets. Government bonds for instance. In fact, T-Bills (short-term US gov bonds) are viewed as ‘risk free’ . They also pay out basically nothing for that exact reason.
Diversification: Don’t put all your eggs in one basket. Spread out the risk across assets that behave and react differently to events and trends to reduce the performance swings of your portfolio.
Going back to our roulette example, put some money on red, some on black, and a handful of smaller bets across the table -> there’s a greater chance of winning, and lower chance of losing.
Roulette is pretty binary, and our investing world isn’t so black and white – this is helpful when it comes to diversification!
One of the most important concepts of diversification is that the risk of the portfolio is NOT the sum of the risks of each asset. Here’s a basic made up example:
- Stock XYZ has volatility of 5% and expected return of 10%
- Stock ABC has volatility of 7% and expected return of 10%
- You build a portfolio of 50% of each asset.
- The expected return of your portfolio will be 10% (50% x (10%+10%))
- But….the volatility of your portfolio will be less than 6%
- This is the only ‘free lunch’ in finance -> you reduce risk and maintain the same reward.
Correlation: When constructing a portfolio, choose investments that don’t move like dance partners in lock step. This is how to make diversification as powerful as possible without needing to buy 1000 securities. The most well-known example of this is stocks vs. bonds. Large growth equities and government bonds perform nearly opposite one another – when one is up, the other is usually down, but the magnitudes of the move may be different.
In this case – adding government bonds to a portfolio of large growth stocks – the bonds act like a habanero, a little bit going a long way. Since they behave much differently versus large cap equities than say, a utility stock, you need less to offset the risk.
Now that we’ve covered the concept of risk, let’s make it personal.
There is a fairly obvious risk tolerance spectrum going from conservative ( close to 0 risk) to aggressive (high risk). We can break this into 5 groups:
To make these more tangible, we can perform the same ranking with typical asset classes which would look something like this:
You can get a sense of how a portfolio mix would get constructed already -> if you’re someone in the middle, you would have a healthy allocation of US Large Caps, and less on the US Treasury and Emerging Markets sides.
The points of debate arise when determining what the respective volatility should be for each risk level. For example, should an aggressive investor target 15% volatility or 18%?
A good benchmark would be the S&P 500. Over the last 10 years , volatility has been around 14% with annualized returns of about the same. That would represent a 100% allocation somewhere around Level 3, maybe slightly higher since the S&P has a lot of tech-growth companies.
However, as we’ve learned having 100% allocated to anything is foolish. By investing in other asset classes we can realize the same return as the S&P with less risk. Adopting this idea could yield a risk/return spectrum as follows:
Supermoment core portfolios keep things simple and use only three risk profiles: Conservative, Balanced, and Aggressive. We’re also able to design them to target lower risk and higher returns than the above table using alternative funds like currency but more on that later!
In many ways designing the allocation scaffold of say a Conservative portfolio is fairly academic. The more subjective question is understanding which profile matches your needs and personality?
Rules of Thumb.
There are several concepts that hold true to help discover your investing profile.
Risk Capacity: This is your ability to take financial risk. We covered this in detail in Module 1. In short, are you in a position to invest at all? If you don’t have an emergency savings fund, it’s unwise to be buying up small cap stocks, but if you absolutely insisted on investing, it would be prudent to put that money into US Government bonds for instance. (Objective measure)
Risk Tolerance: All about personality and being able to sleep at night. (Subjective measure)
Time: How long can you park your money? The mainstream way of saying this is usually ‘‘time to retirement’ but the general truth is the longer you can wait, the lower the risk on any type of investment, particularly stocks. (fairly objective measure)
It’s useful to observe this in order – i.e. your risk capacity should have more bearing on your investing profile than anything else.
The other reality to keep in mind is that your profile will change. It evolves alongside your goals, career, family, and personality.
Here’s an interactive survey to help understand your risk tolerance. It’s a Google Sheet, so go File > Make A Copy, and you’re good to go.
Remember this isn’t an exact science and meant for educational purposes only, but should be helpful nevertheless!