How To Have A Risk-Appropriate Asset Allocation When Investing


Since 2009, one of the things I have focused on is trying to help readers have a risk-appropriate asset allocation. A risk-appropriate investor invests according to their true risk tolerance. When you invest according to your true risk tolerance, you usually become a calmer, wealthier person.

Over the long run, your investment asset allocation is highly rational. You will make adjustments during various economic cycles until you reach the point where you feel fine no matter the environment.

In other words, you will discover your true risk tolerance through experience and intentional financial planning. As your financial situation and goals change, so will your asset allocation.

Understanding your true risk tolerance may take between 10 – 20 years. Therefore, it can be dangerous to only listen to someone who has only invested during a bull market or bear market. Over the past 27 years of investing, I’ve discovered we often overestimate our risk tolerance.

To make financial adjustments, you must be in tune with yourself. It’s worth being immersed in the world of personal finance by subscribing to newsletters, listening to podcasts, and reading books.

After a year of not checking your portfolio, it is easy to misremember what you invested in and how much. Please don’t get blindsided by a bull or bear market because you thought your asset allocation was one way when it really was not.

A Risk-Appropriate Asset Allocation In A Bull And Bear Market

During a bull market, if you have a risk-appropriate asset allocation, you will feel good knowing your net worth is invested in enough risk assets to benefit from a strong economy. Thanks to your discipline, investing FOMO doesn’t overwhelm you to abandon your asset allocation for much riskier assets than you can really take.

The only time your asset allocation would become riskier is if your risk tolerance has materially increased due to a sudden financial windfall. Or you may become more bullish on your income potential or managing your future expenses.

During a bear market, if you have the right asset allocation, you are relatively at peace because you know drawdowns are a part of investing. Although it still stings to lose money in a bear market, you feel comfort knowing your realistic net worth downside potential.

Veteran Investors Know Their Downside Risk

Based on history, the average drawdown in the S&P 500 is about 35% and lasts about between 12 – 15 months. The average historical returns for the S&P 500 since 1926 is about 10%, with dividends reinvested.

For real estate investors, you also understand the risks involved. During the global financial crisis, the median sales price of houses sold in America declined by about ~19% from 1Q2007 to 1Q 2009. The average returns for real estate is between 1% – 2% above the average inflation rate.

The Easiest Way To Know Whether You Have The Right Asset Allocation

It takes trial and error to find the proper asset allocation that fits your risk profile. As a result, an investor likely needs to go through two economic cycles to find their risk-appropriate asset allocation.

But an easy way you can tell whether your asset allocation is inappropriate is if you find yourself getting overly emotional during downturns or overly exuberant during upturns.

For example, if you find yourself losing patience with your spouse and kids more often when stocks are going down, it’s probably a sign you’ve invested too much in stocks. Losing money from your investments shouldn’t negatively affect your relationships with people who have nothing to do with your investment choices.

If you find yourself binge eating and gaining weight or drinking heavily during a bear market, your allocation to stocks is probably too high. Same thing goes for if you start experiencing chronic back pain or other physical ailments out of the blue. Your body provides great warning signs if you pay attention.

On the flip side, if you find yourself hugging and kissing everyone more than usual when the S&P 500 is up three percent when the average daily percent move is one percent, beware! You’re likely counting too much on your investments to reach your goals. Bigger emotional highs tend to lead to bigger emotional lows.

As an investor, the emotions you experience shouldn’t be above or below your normal emotional band. Otherwise, adjustments are in order. Ideally, your investments are shifted to the background so you can focus on enjoying your life.

Examples Of Emotional Explosions

One of the benefits of operating a personal finance site is getting to read everybody’s comments whenever I write a post. I can often tell someone’s state of mind because they are clearly reflected in the way they comment. Readers can also understand my state of mind based on the way I write my posts.

In How To Enjoy Your Life After The Fed Ruins The World, I decided to make lemonade about an unfortunate situation. As a personal finance writer, I like to have an opinion, create imagery, and provide solutions. The post’s main goal was to help us accept the reality of a global recession and make the best of it.

But because the post got picked up by a reading app called Flipboard, over 10,000 new readers who are unfamiliar with my background read my post. And some of the comments were very emotionally charged and full of political references, when the post was not political at all.

Happy people don’t go bashing people over social media and in the comments section of articles. But based on the reaction to that article, it seems like there is a lot of fear out there at the moment. The fear of losing a lot more money and the fear of your political party not winning the mid-term elections.

Investors who commented courteously likely have risk-appropriate asset allocations.

Translate Money Into Lost Or Gained Time

I have attempted to quantify your risk tolerance by introducing FS SEER. SEER stands for Samurai Equity Exposure Rule. The concept should eventually take off because it is completely rational.

Why do we invest? To potentially make more money passively. Why do we want to make more money passively? To do more of the things we want and less of the things we don’t. Why do we want more freedom? Because time is limited. We can always make more money, but we can never make more time.

So logical!

Therefore, you can quantify your risk tolerance by calculating how much TIME you are willing to spend working to make up for your potential losses. The longer you are willing to work to make up your losses, the more risk loving you are and vice versa.

FS SEER Formulas To Quantify Risk Tolerance

Risk Tolerance Multiple = (Equity Exposure X 35%) / Monthly Gross Income

The Max Recommended Equity Exposure =  (Your Monthly Salary X Risk Tolerance Multiple) / 35%

* 35% is the average bear market drawdown. The 35% can be adjusted based on your drawdown forecast.

Have a look at my FS SEER risk tolerance chart. It states that once you are willing to spend 24 months of your life making up for your loses, your risk tolerance is high. It says you are a conservative investor if you are unwilling to spend more than 6 months of your life making up for your potential losses.

The FS SEER formula can then be used to calculate your recommended equity exposure maximum based on your income and risk tolerance.

For example, if you have over $1 million in equities with a $10,000 monthly gross income, you are considered to have an extreme risk tolerance. You are OK with spending 36 months working to make up for your potential equity loss of $360,000.

If you make $10,000 a month and feel you have a moderate risk level, then having $342,857 to $514,286 in equities may be appropriate. Play with the formula and variables yourself.

Learn how to quantify your risk tolerance using FS SEER

Where Is My Nobel Prize In Economics?

Whether you agree with the variables in my formula or not, the framework is there to help you become a more risk-appropriate investor. Time is more valuable than money.

Maybe you think having an Extreme Risk Tolerance is being willing to work 120 months to make up for your losses. If so, your Risk Tolerance Multiple jumps to 120 from 36. For a $10,000 monthly gross income, the maximum equity exposure you are recommended to have is $3,428,571 ((120 X $10,000) / 0.35).

Personally, I’m unwilling to spend more than 12 months making up for investment losses. Therefore, I consider myself a moderate-to-conservative investor. I’ve got less than three years until my daughter attends school full-time. Hence, I need to make the most of it.

I see no tenured professors with PhDs at the most prestigious universities coming up with such a practical formula for millions of investors. Instead, there are numerous research papers with complex formulas the average person will never read or utilize.

It doesn’t matter how great an idea is if it is not easily implemented. Theory is not as important as practice!

Real-World Experience Matters When Investing

Should I be considered smart for coming up with something unique, simple, effective, and practical? Of course not. I came to America at 14 and attended public schools. The only way I could have created this helpful formula is through firsthand experience.

Losing money during the 2000 dot com bubble was difficult. So was investing for a whole decade and not seeing much in total returns. So I made adjustments by investing more in real assets.

Seeing 35% of my net worth that took 10 years to accumulate disappear in six months was very painful. But the 2008 global financial crisis taught me to not extrapolate my income or returns far into the future. The crisis also reminded me about the importance of diversification and to not confuse brains with a bull market.

As a practitioner of early retirement since 2012, I’m experiencing firsthand what it’s like to not have day job income. The scarcity of time is one of the main reasons why I negotiated a severance at 34 in the first place.

Retiring early was a hedge against dying early so I could live my life with the least number of regrets.

Your Rationality Will Eventually Get You To An Appropriate Asset Allocation

One of the best things about being human is that we are all long-term rational. In the short run, we will experience mistakes. In the long run, we learn from our mistakes and make wiser decisions.

We won’t keep making the same mistakes over and over again. Otherwise, we’d be insane! Instead, we will either learn from our mistakes or learn from people who’ve been through what we may go through.

If you are feeling highly emotional during this latest bear market, then accept you have an inappropriate asset allocation. You will either have to lower your exposure to risk assets by selling some assets or saving and investing more in lower-risk or risk-free assets, or both.

My favorite way to reduce the percentage of risk assets to overall net worth is by raising more cash and buying more Treasuries and other lower-risk investments. I don’t enjoy selling stocks or other risk assets after they’ve collapsed. Because eventually, such assets tend to recover.

My Latest Asset Allocation

Since 2003, I have preferred real estate over stocks. Seeing stock fortunes disappear overnight in 2000 made me seek wealth in real assets that are much less volatile. As a result, roughly 55% of my net worth is in real estate and ~25% of my net worth is in stocks today.

I did have about 30% of my net worth in stocks and 50% in real estate before the bear market altered the percentages. 30% is my stock allocation limit because I can’t stand losing more than 10% of my overall net worth from stocks.

Losing money in stocks still stings. But it’s not painful enough to negatively affect my mood for long or alter my daily life. Stocks would have to fall by 70% from peak to trough for me to consider going back to work.

The value of my physical real estate portfolio is almost irrelevant due to the lack of debt. I primarily own real estate for shelter and semi-passive income. I plan to hold my properties forever.

Every time we go through a bear market, I’m reminded of how useless owning stocks is if they don’t pay a dividend or if they are not occasionally sold for profit. Please don’t forget to enjoy your gains once in a while!

I’m nibbling on the S&P 500 down 25% as I mentioned in my post on how I’d invest $250,000 cash. But I’m also happy to own Treasury bonds yielding ~4.5% and hunt for another sweet property in one to three years time.

With a risk-appropriate asset allocation, I’m able to better focus on spending time being a father and a writer. If I find myself unable to freely do these two things, then I will change my investments accordingly.

Questions And Recommendations

Readers, how have you found your risk-appropriate asset allocation? How long did it take for you to get your portfolio aligned with your risk appetite? What is your net worth asset allocation look like?

To gain an unfair competitive advantage in building wealth, read Buy This, Not That. It was written exactly for volatile times like these. As others blow up their finances with an inappropriate risk tolerance, you’ll navigate the rocky waters better. The book is on sale at Amazon today. I synthesize my 27+ years of investing experience to help you make better financial and life decisions.

For more nuanced personal finance content, join 50,000+ others and sign up for the free Financial Samurai newsletter. I recap the week’s most important events and share my thoughts to help you build more wealth and confidence. Financial Samurai is one of the largest independently-owned personal finance sites that started in 2009.



Source link

Leave a Reply

Your email address will not be published. Required fields are marked *

@2022 Fintech Technologies Limited. All Rights Reserved