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Perils of Crashing Through Risk Tolerance

People find their true tolerance for investment risk in two ways – building up to it or crashing down through it. Building up involves taking on more risk as investment knowledge and experience increases. Crashing down occurs when a person overestimates their ability to handle risk and they blow apart their portfolio during a bear market.

Finding risk tolerance by building up is a much better option. It keeps an investment plan on course during all market conditions and avoids the financial and emotional damage caused by blowing up in a bear market.

Each of us has a natural tolerance for risk that doesn’t change much throughout our lives. If we knew exactly what this level is early on, we could adjust our portfolio allocations over our lifetime to ensure we don’t surpass it.

Unfortunately, no one can know precisely what their tolerance for financial loss is until they hit it, and that means experiencing one or more bear markets. Many people thought they knew their level in 2007 and over-allocated to stocks only to end up dumping equity in the market collapse that followed.

If the decision to capitulate in a bear market was quickly reversed when a bull returned, then the damage could be maintained. Unfortunately, this seldom occurs. Wholesale selling during a bear market causes long-lasting collateral damage.  It often leads to a negativism about stocks in general and keeps investors out of the market or under-allocated to equity for prolonged periods.

Figure 1 highlights the monthly cash flows into and out of equity mutual funds since 2007. I believe it illustrates the prolonged effects of too much risk. Outflows have persisted since hitting bottom in March 2009 even though the stock market has doubled since that time. Some outflows have converted to equity exchange-traded funds (ETFs) in recent years, but those inflows are considerably smaller than equity mutual fund outflows.

Figure 1: Monthly Change in Total Equity Mutual Fund Holdings (in millions $)

Source: Investment Company Institute, Estimated Long-Term Mutual Fund Flows Data, Oct 24, 2012

Attempting to measure risk tolerance has never been easy and is especially difficult for new investors who have never been through a bear market. Many Wall Street firms and mutual fund companies have tried to commoditize this process by developing risk assessment questionnaires. This method involves answering a limited number of what-if questions, analyzing the answers, and recommending an allocation to equity.

A risk assessment question may be, “Would you sell, hold, or buy more if your portfolio lost 20 percent?” The answer to this question and others would be fed into a computer and an algorithm would decide a person’s tolerance for risk and an optimal equity allocation.

Unfortunately, risk assessment questionnaires are flawed in many ways. Noted academic researchers Carrie Pan and Meir Statman found major issues with the process and published their findings in a recent paper entitled, Questionnaires of risk tolerance, regret, overconfidence, and other investor propensities.

Pan and Statman isolated several problems with the methodology. First, investors may have different risk tolerances for different financial goals. Trying to lump all goals into one generic risk tolerance misses the complexity of the question. Second, the link between answers and recommended portfolio allocations appear to follow opaque rules-of-thumb rather than a transparent economic or behavioral theories. Third, a person’s recent experience and circumstances prior to asking the questions affected the outcome. For example, people tend to answer differently in a bull market than they do in a bear market.

It’s been my long held belief that investors should wait until a bear market before attempting to assess their risk tolerance with a questionnaire. A down market ensures a more conservative outcome. This doesn’t mean the outcome will be a person’s true risk tolerance, but at least it won’t place their portfolio in an equity allocation they can’t handle during the next bear market.

One interesting aspect of assessing risk tolerance is the wide perception that young people have a greater ability to handle risk than older people. That’s only true from a time perspective, not a behavioral one.

Young investors are often told to be high in equity because they “have time”. This advice is well-meant, but it is also ill-conceived because it sets many young people up for capitulation during their first bear market. That’s not in their best interest short-term or long-term.

Age does not have much impact on one’s maximum tolerance for risk, but it does impact their knowledge of a true risk tolerance level. Young people have a lower realized level than more experienced investors. In other words, the experience of age helps an older investor stay invested during a bear market. This is an important point that age-based asset allocation models often neglect.

A better idea is the Flight Path approach to age-based asset allocation, as I described in a previous article. It introduces risk to younger investors gradually so that they slowly realize their tolerance for risk and are better able to control their actions in a bear market.

Figure 2 highlights a recent survey of mutual fund investors that supports the flight path method. It shows that Generation Y (born 1977-2001) believe they have a lower tolerance for risk than either Generation X (born 1965-1976) or Baby Boomer (born 1946-1964). This finding is exactly opposite of the perception that young people have a greater ability to handle bear markets than older people.

Figure 2: Willingness to Take Financial Risk by Generation

Source: ICI Research Report; Profile of Mutual Fund Shareholders, 2011, page 89

Notice the higher percentage of Generation Y investors who are unwilling to take any risk (19% for Gen Y versus 9% for Gen X and 10% for Boomers). The data from “average risk” to “substantial risk” also confirms that Generation Y investors are the most risk-adverse group. Only 73 percent would accept average to substantial risk while 79 percent of Baby Boomers and 85 percent of Gen X were willing.

Assessing one’s risk tolerance by taking a risk assessment questionnaire during a bull market or following age-based rule of thumb isn’t a good solution for most people. These methods often expose people to too much risk and result in more harm than good. A better solution is to build up to a risk tolerance level as I described in the Flight Path article. Building up to a risk tolerance level increases the success rate of an investment plan and that results in higher returns with less overall risk.