Should Risk Tolerance Determine Asset Allocation?

2008 May 19
by Kyle Bumpus
from → Asset Allocation, Investing And Investments

Last week, Morningstar writer Christine Benz wrote a piece entitled Four Investment Rules To Ignore in which she details investment “rules” that may seem logical at first glance but are actually counterproductive.  It’s all pretty standard advice except for the third point.  According to Christine,

“…an individual’s assessment of his or her risk tolerance should play second (or maybe third or fourth) fiddle to other considerations–such as time horizon, the size of your nest egg, your savings rate,  and the expected returns from various asset classes…”

This, of course, runs counter to a lot of advice you’ll hear about how to construct a long-term investment portfoliol.  I’ve written previously about risk tolerance and risk avoidance but nowhere have I addressed to what extent an investor’s risk tolerance should play in their asset allocation.  In fact, I’ve always kind’ve taken for granted that risk tolerance should determine asset allocation, but now that I think about it, I think Christine has an excellent point.

Young Investors Are Too Conservative

I’ve always had a high risk tolerance.  Coupled with the fact that I’m still in my mid-20′s and have decades before retirement, I have no trouble sleeping at night even though I have a fairly aggressive portfolio.  Most unexperienced investors (which probably constitutes the vast majority of investors), however, aren’t so comfortable with risk.  In fact, according to US News, 401k investors invest much too conservatively.  Investors in their 20′s, who should theoretically be at least 80% to 90% invested in the stock market, invest a relatively modest 50% in stocks mutual fund and another 19% in balanced funds with the rest either in company stock (at 10%, that’s probably too much) and bond/stable value funds.  While a 50% stock allocation is better than nothing, these young investors are taking the much larger risk of not having enough money to retire comfortably in return for reducing short-term portfolio volatility.  I agree with Christine that this isn’t an intelligent trade-off to make.

Base Your Asset Allocation On Hard Facts, Not Your Gut

Of course, nobody is going to tell you risk tolerance isn’t important.  It is.  But at a certain point, practical considerations have to take precedence.  There is simply no way a young investor will be able to retire comfortably without the growth stocks provide.  Extremely risk-advers individuals should go the extra mile educating themselves about the risk and return characteristics of various asset classes to help quell your stomach in hard economic times.  In instances of extreme risk adversity, I think it makes sense to push yourself a bit beyond your comfort zone and deal with the consequences.  For example, if you’re comfortable with having 30% of your portfolio in stocks, you might force yourself to invest 50% of your assets in equities based on a well-researched and informed understanding their superior risk/return characteristics.  Over time, I think the logical, well-informed part of your brain will begin to take over and you’ll gradually become more comfortable with risk, allowing you to raise your stock allocation to perhaps 60% of your portfolio and so forth.  You may never be totally comfortable with market gyrations, but knowing how the market works will help quiet the panicky voice in your head every time the DOW drops.  Your 401k balance will thank you.

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3 Responses
  1. 2008 May 19

    I think knowledge is a big part of it. The fact that these “conservative” investors have 10%+ invested in their company stock indicates that they don’t know enough to evaluate the riskiness of their portfolio or just as likely they haven’t bothered to do so.

  2. 2009 August 13
    Steve G. permalink

    The point is well taken, and raises the issue of the separation between behavioural finance and rational decisions. Fortunately/Unfortunately investors more often than not are ruled by emotions.

    Nonetheless in my experience if the investor has not had the chance to experience at least one downturn, he/she will not be certain how they will react when the time comes to pay the piper. Once you’ve seen your investments recover, you are most likely ready to withstand the future downturns because you have the experience under your belt. Until that time, risk tolerance will always be the wild card. Since the best laid plans will run amok once panic selling kicks in.

    I remember many moons ago, when I learned that small cap stocks had always outperformed large cap stocks, I told myself, why then, would anybody invest in large caps? Just keep the small caps for a long time, at least 10 years, since very few have shown losses over that time period, and sleep tight!

    If you’re ready to ride the roller coaster…you will be o.k…but you better know yourself really well!

  3. 2010 July 1
    Thurston permalink

    I disagree. There is nothing worse than not being able to talk a client out of jumping off a cliff. That usually only happens when their asset allocation doesn’t match their tolerance for risk, (which I more kindly refer to as their tolerance for change). Losing out on a percent a year because you’re being a little too conservative is much better than selling at the bottom of a bear market because once someone leaves the market, it’s very difficult to get them back in. In fact, more often than not, they’ll repeat the same mistake and only agree to get back into the market once it’s recovered and due for another bear market. Therefore, risk tolerance–along with time horizon, rate of savings, & net worth–is and will continue to be the major determining factor when recommending asset allocation.

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