How investors can narrow the gap between risk capacity and risk appetite
Be informed about trade-offs before you make next move, Tom Bradley writes.
Investors' willingness to take risk doesn't necessarily equal their capacity to take risk, since they often take either more than they should, or not enough.
By risk, I'm talking about the variability of returns, specifically the likelihood that they will be negative for periods of time. To keep it simple here, riskier means stocks and less risky means guaranteed investment certificates and high-quality fixed-income securities.
Many factors help determine both your capacity and appetite for risk, such as age, how much you make, the stability of your job, your net worth and the shape of your household balance sheet — that is, how much debt you have against your assets.
The number of people who depend on you is another important factor, as is the opposite situation. For example, having parents who are willing to backstop you, perhaps through their estate.
If facts are facts, where does the gap between risk capacity and appetite come from? There are two primary causes. The first is how and when you were brought up. Your personality and history affect your interpretation of the facts and heavily weigh on investment decisions.
Morgan Housel, a partner at Collaborative Fund Management LLC, notes that how we perceive risk is heavily influenced by what was happening in our “teens and twenties.” If markets were good, you're likely to be more comfortable investing in stocks in subsequent years. If you grew up during an inflationary period, you may be more likely to own gold. Your personal history has a lasting impact on your outlook and ability to take risks.
Another reason for the gap is a lack of appreciation of time frame, the importance of which is huge.
Money you'll need in the next few years has little room to take risks. It must be there when you need it. On the other hand, money invested for a retirement that's years or decades away provides plenty of risk capacity. Markets can bounce around all they like, and the ultimate outcome won't be affected.
Investors with a long time frame have a big advantage. They shouldn't let it go to waste.
In extended bull markets such as we're experiencing today, it's common to see people taking on more risk than they have the capacity for.
To help in these cases, I talk in terms of when, not if: “When the market is down 20 per cent, what's your plan?” I also refer to dollars when I can as opposed to percentages: “When this happens, your portfolio will be down $100,000.”
A more chronic problem, however, is that too many investors use only a fraction of their risk capacity. I hear it all the time: “I want to earn a better return, but don't like seeing my portfolio go down.”
If you're in this camp, there are things you can do to narrow the gap.
First, make sure you know the consequences of your conservatism. Earning an average return of three per cent over 20 years will grow a $500,000 investment to $900,000. A six-per-cent return will follow a bumpier road, but the number at the end will be $1.6 million.
Perhaps the best way to narrow the gap is to divide your portfolio into separate buckets based on time frame. For instance, put money you'll need in the next three years in secure savings vehicles. For money needed in four to eight years, choose a conservative balanced fund. And for amounts you won't, or can't, touch for nine or more years, hold funds that are primarily invested in stocks, since your priority is the highest return, not the smoothest ride.
If the amounts properly line up, you may be able to use your different accounts as your buckets. For example, your taxable account covers years zero to three. Tax-free savings accounts target your needs in years four to eight, and registered retirement savings plans will be focused on
nine-plus years.
Another useful approach involves moving a little money into stocks every month through automatic contributions, or what's called dollar-cost averaging. This takes the emotion out of each purchase and gives you time to get used to taking more risk.
At the end of the day, you may not want to completely close the gap because you don't need a higher return to enjoy a comfortable retirement and want to sleep well at night.
Nonetheless, you should be informed about the trade-offs you're making and the valuable capacity you're not taking advantage of.