Most investors, to answer a famous political question, are better off than they were four years ago. Even a stodgy, plain-vanilla portfolio of 60 percent stocks and 40 percent bonds has returned more than 10 percent annually since mid-2009. As long as you were invested in any major asset class other than cash, your portfolio has probably grown, perhaps significantly.
But now investors have reached a fork in the road. There’s reason to be cautious of both major asset classes, with concerns that returns of either stocks or bonds (with a few uber-pessimists claiming both) won’t be as generous as they’ve been in the last four years. Despite all the economic chaos left in the wake of the 2008 financial crisis, stocks have steadily returned more than 140 percent since 2009, with not so much as a market correction (that is, a decline of more than 10 percent) since the debt ceiling crisis in the summer of 2011. And bond returns have been goosed by various Federal Reserve initiatives, such as keeping short-term interest rates at rock-bottom levels and purchasing bonds on the open market, driving up bond prices and reducing yield to record lows.
So how should you position your portfolio? There’s no one-size-fits-all answer. Even target-date funds, those premixed funds in most employer’s savings plans, may not be the best portfolio for people retiring in, say, 2030—although it may be appropriate for many. To determine the best fit for you, you’ll need to learn your risk tolerance. As important, you’ll also need to know how to avoid common investing mistakes, no matter which way investments head.
Risk tolerance isn’t the same as risk perception. Tolerance is a constant, while perception is more easily swayed by previous performance. It’s human nature to be wary of an investment that recently burned you, as stocks did in 2008. It’s also human nature to feel euphoric about investments if they triple in value in a matter of months, as many tech stocks did in 1999.
The difference: The tingling or burning feeling you get from stock and home investments affects your risk perception, but not your risk tolerance. It’s a cognitive bias, known as the recency effect. More recent events will have a greater impact on your perception of an investment than the complete historical record. But your perception doesn’t affect your risk tolerance. Risk perception, though, can change with the circumstances.
And on top of those two risk concepts, there’s risk capacity, or how able one is to assume risk. An extreme example makes the point: A millionaire has more of a capacity to wager on a $100 coin flip (for charity, of course) than a young college graduate with little in his bank account. That doesn’t mean either will behave according to his means; perhaps the millionaire is a churlish skinflint and the graduate is a thrill-seeking adventurer.
And last, there’s required risk, or how much risk we as investors need to take to meet our financial goals, which, for most of us, is a stable retirement. An investor may be naturally risk averse, but if he doesn’t take enough risk, he may never be able to accumulate enough to last through his retirement years.
Three of these concepts—risk tolerance, risk capacity, and required risk—are ideally taken into account when building a model portfolio. (The fourth, risk perception, is noise borne of recent performance and events that investors need to tune out.) Without being mindful of each of them, there’s a greater chance you’ll either be too timid or too aggressive with your investments than you should be.
If you’ve been to a financial adviser or invested even a little money with an online brokerage, you probably remember being administered a brief quiz. Answer 10 or so questions, and voilà, a profile of what type of investor you are appears, along with a recommended portfolio. For a list of some typical questionnaires, see the box below.
So how can a quiz reminiscent of what you’d find in popular magazines help you reach a financial goal? According to some recent studies by behavioral finance researchers, they haven’t always served investors well, precisely because they measure risk perception instead of risk tolerance. If investors, or their advisers, rely too heavily on the results of those questionnaires, they’re likely to build an asset allocation that’s either too aggressive or too timid relative to their tolerance for risk.
Regardless, none of the quizzes are going to be wildly wrong, insofar as they capture risk tolerance. They won’t place a young, aggressive investor in an income-based portfolio, or put half of a conservative retiree’s savings in emerging markets. If one questionnaire isn’t enough, there’s no reason not to take others to be certain. But they can come up short in capturing other attitudes, particularly risk capacity.
For instance, someone with a strong family history of a hereditary disease may need a less aggressive portfolio than the questionnaire would indicate. If you don’t think that a risk-tolerance questionnaire sufficiently captures your particular circumstance, you may want to consult with a financial adviser. He or she will, in most cases, also employ other financial-software tools, such as MoneyGuidePro or Financeware, to supplement a risk-tolerance questionnaire.
So once you’ve established what your risk tolerance is—aggressive, conservative, or in-between—the trick going forward is to stick to the plan throughout the market’s highs and lows. It’s not easy. But there are some steps you can take to do it.
One of the best ways to stick to your asset allocation is to periodically rebalance your portfolio. Annual rebalancing—say, every January—is usually sufficient. Do it more frequently, and you’ll be incurring extra costs in commissions and possibly capital-gains taxes. Less frequently, and your portfolio is more likely to drift from your prescribed allocation. For example, a simple portfolio comprised of 70 percent stocks and 30 percent bonds in 2011 would be 75 percent stocks, 25 percent bonds two years later.
Understanding your tolerance and capacity for risk and then creating and sticking to a portfolio appropriate for it can, as Warren Buffett once wrote, “control the urges that get other people into trouble in investing.”
Risky business
At the websites below, you'll find four typical risk-tolerance questionnaires. In most cases, you’ll show a similar risk tolerance no matter which test you take.
Index Fund Advisors
Rutgers University
Vanguard
Wealthfront
This article also appeared in the November 2013 issue of Consumer Reports Money Adviser.
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