[Today’s post is from Crispy Doc, an emergency physician who lives and works in California. One of the key determinants of your stock/bond allocation is your risk tolerance. Risk tolerance doesn’t have a precise definition and there is no standard way to assess or define it. In this post, Crispy Doc describes a nice rule of thumb for assessing your risk tolerance. This article previously ran on Crispy Doc’s blog in May 2017. -WSP]
One of the challenges for a new investor is determining your risk tolerance, which is how aggressively to invest your savings. There are several considerations to factor into determining how much volatility you can handle – in this case volatility means what percent of stocks (vs. bonds) you feel comfortable owning in your asset allocation. 80/20 would be considered aggressive or high risk, while 20/80 would be considered conservative or very low risk. Like running a disaster preparedness drill at your hospital, determining your risk tolerance is at best an approximation of what you think you can handle in a crisis.
Understanding the Life Cycle of the Market
My investing history happens to encompass the two most recent bear markets: a 58% percent drop from 2000-2002 and a 57% drop from 2007-2009. These were the times when the finance media was screaming the loudest and receiving the greatest exposure. Family members well into their retirement who had been heavily invested in stocks during the latter bear market pulled out of the market completely – locking in their losses and missing out on the tremendous upside from the ensuing bull market. Why did they pull out? They held too many volatile investments – they couldn’t sleep knowing the losses their portfolio had taken on, and they had overestimated their risk tolerance.
How did I stay invested in a largely equity portfolio? Good old-fashioned ignorance. I’d love to say I was brave, but mostly, I just ignored my financial statements and continued to maximally contribute to my retirement accounts. At the time we used a financial advisor, and I basically continued to save and invest as high a proportion of my income as possible. How might I have handled it today? Hopefully in exactly the same way, minus the advisor fees.
Bear markets are a natural part of the market cycle, and knowing history (they come, they go, the market has only ever gone up over time) while maintaining perspective (a bear market means stocks are on fire sale – time to load up, woohoo!) means I framed the situation differently. My existing equity investments were not lost money, but money bound to recover. My new equities purchased were not sudden stinkers – nothing had fundamentally changed about the thousands of viable businesses with excellent products that I collectively owned in my total stock market index fund – but amazing bargains I was able to purchase at pennies on the dollar. In fact, for a young investor, one of most ideal situations you can hope for is having the good fortune of loading up on stocks during a bear market early in your investing life.
The Sleep Test
A well-regarded rule of thumb is to determine how much of a loss in your portfolio would cause you to stress out and lose sleep. If you determine a 30% drop would meet your ulcer-development threshold, then double that number and plan to hold no more than 60% equities. Many wise investors suggest taking it one step further for brand new investors: double the number and subtract 10, for 50% stocks, because behavioral finance studies have demonstrated that until you face an actual disaster, you are likely overestimating your risk tolerance.
Time is on your side
Early in your career, you will be relying more on your intellectual capital and less on your financial capital, so it is common to emphasize growth with greater stock allocation. A younger doctor whose investments tank can make up any financial shortcomings by working longer and harder. Younger investors can assume greater volatility (more stocks = greater risk and commensurately greater reward) because they have a longer time horizon to allow their investments to recover – all those peaks and valleys that can seem frightening when looking at market performance graphed out over 5 years tend to smooth out in a reassuringly gradual upward trajectory over a 20 or 30 year period. Front loading your retirement investments also allows the magic of compound interest to work in your favor earlier.
Build in a Glide Path
As you near retirement and you realize that you “can’t take much more of this shift,” you will likely not have much more work life left in you. Consequently, you will be depending on your cumulative investments to support you financially, so you’ll want to be more risk averse and focus on capital preservation. A glide path, which transitions your investments from higher volatility (stocks) to lower volatility (bonds) as you approach retirement factors in your lower risk tolerance over time.
Conclusion
Subject yourself to the theoretical sleep test to determine your level of risk tolerance and allocate your assets accordingly. Understand the life cycle of the market, accepting that corrections and bear markets are inevitable stops on the road to wealth. Build a glide path into your plans, so that you take on the greatest risk early in your career, when you are best able to weather high volatility, and reduce your risk exposure as you approach retirement.
I think the notion of a Glide Path is a good one. Realizing that asset allocations & risk tolerance are highly subjective & individual, what are your thoughts on Crispy Doc’s plan that you linked to?
JR,
I’m obviously a big fan of having a Glide Path, both for your portfolio and your career.
I’d welcome others’ comments (feel free to be candid about its shortcomings), but I can certainly tell you that my portfolio is more aggressive than I’d recommend for the average MD.
Since publishing the original post, I’ve amended my plan in the following ways, with the caveat that all changes have been considered for more than the 3 month minimum and received my wife’s formal approval.
a) Probably preferable to describe allocation based on years from official retirement (10 years before, 5 years before, at retirement, 5 years after, 10 years after).
b) We decided to dial back to 80/20 5 years ahead of schedule (I turned 45 this year) because my wife’s risk tolerance was lower than mine. Less about succumbing to CAPE fear than about compromise and recognition of her threshold for sleeplessness.
c) We’ve extended our expected career longevity in emergency medicine by doing less of it. Since we aggressively front-loaded our retirement savings, we now have a longer runway to retirement where we plan to work less clinically while simultaneously launching our location-independent exit strategy / second act careers (my wife’s is already a successful business; mine is incubating).
d) 10 years after retirement I’d consider altering my allocation from the original terminal allocation of 60/40 to a terminal 70/30 allocation once I feel I’m past the initial most worrisome period for sequence of return risks. I might keep 3 years of expenses in a CD or other liquid account before doing this to provide sleep insurance, but the more I read, the more tempting this would be.
Otherwise the asset classes and tax-efficient allocation remain unchanged.
Hope this helps shed light on both my youngster’s hubris and my more tempered salt-and-pepper haired evolution.
Fondly,
CD
Good write-up on an important topic.
Unfortunately, most of us need to personally experience a crash and a bear market to truly know our risk tolerance. Taking a 10 question online survey just doesn’t cut it.
Many current investors (especially those on the FI journey) have never experienced either and don’t truly know how they will emotionally respond. Time will tell.
I have experienced market drawdowns in 1987, 2000, and 2008. I don’t enjoy them one bit. It changes my cost structure, asset allocation, mood, and thinking. I don’t completely panic, but I do feel it.
I decided on a 40:40:20 (Stocks:bonds: other) for me to capture upside gain without the big drawdowns but everyone needs to figure this out for themselves.
Wealthy Doc,
WCI informed me recently that you were around back when he began and most other physician bloggers were spermatozoa, so your experience and caution are a welcome counterpoint to the giddiness of the current bull market.
Out of curiosity, what is your 20 other allocation? Real estate?
Thanks for weighing in,
CD
Definitely an article everyone needs to be aware of. It is definitely something to say well I will do this and should be fine after answering a simple survey, but to actually go through it is another thing.
I think I have a higher risk tolerance because I’m more concerned about developing passive income streams that can provide a floor in retirement when I get there. If you can live on the passive income stream while the world is crashing you won’t have to lock in losses by selling falling assets and can thus wait for it to rebound.
There is a quantitative way to consider this using something called Monte Carlo analysis. The Monte Carlo calc I use is at PortfolioVisualizer.com. You enter your assets and the AA for example VBMFX VTSMX 50/50 and pick a length of distribution period like 30 years and the amount like 4% and push the button. You will get a read out of % success, a graph of how soon the AA fails and a distribution of ending portfolio value depending on projected market conditions. The calculator does not inform you about “the future”, it informs you about “probable futures” (it calculates 10,000 futures) and then orders them according to likelihood. In accumulation your concern is profit, In retirement your concern is failure. You can extend the length of distribution (retire early), change the AA, WR, SORR asset mix (like add a foreign fund or REIT) etc to get a more tweaked understanding of where you need to go and how those choices affect you. For me 95% success is adequate, but my portfolio is large enough to support 99% success. Beyond that you merely perform the mechanical functions of portfolio management, namely yearly contribution and asset re-balancing in accumulation and controlled spending and re-balancing in retirement. In good stock market year you sell a little of your stocks high, that profit in bonds for later redistribution. In a down market you sell some of the bonds to buy some cheap socks low. How much to buy and sell? Just do what the AA tells you to do. Soon enough you’ll be wealthy and nothing to worry about as long as the country stays intact. This is as good as you’re going to get. Everything other “scheme” of higher “risk tolerance” is playing the lotto and is irrational and testosterone driven. I sleep just fine 100% of the time. You need no other scheme than this to be a successfully retired investor. If you want to play the lotto, a ticket is $2. Another way to do this is use all the tools at Personal Capital to monitor and plan your portfolio. All of this is built in with that aggregator. PC is more advanced since it uses rules to try and minimize taxes in the distribution period.
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