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Asset Allocation Guide: What is your risk tolerance?

Today, we continue our series designed to help you determine the best way to allocate your assets.

Warren Buffet advised investors that “Success in investing doesn’t correlate with IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people in trouble investing.”

It’s my experience that there are two keys to being able to maintain control over those urges that get investors into trouble. The first is to know your financial history. That means knowing that stocks are high-risk investments, subject to large losses (we’ve had three bear markets with losses of about 50 percent or more in the last 40 years), and serious crises come with great frequency. As Napoleon is attributed to saying: “Most battles are won or lost [in the preparation stage] long before the first shot is fired.” Forewarned that regular crises are the norm in investing enables you to be emotionally prepared to deal with them. 

The second key is that in order to deal with the many crises you’ll have to face, and the bear markets that accompany them, with equanimity, you have to make sure that you don’t take more risk than you have the ability, willingness and need to take.

Today we’ll focus on the willingness to take risk — what’s typically referred to as your risk tolerance. As you’ll see, finding the answer is more of an art than a science. 

The willingness to take risk

The first step in finding your willingness to take risk is to take what I refer to as the “stomach acid” test. Ask yourself this question: Do you have the fortitude and discipline to stick with your predetermined investment strategy when the going gets rough? Remember, when the only light at the end of the bear market tunnel seems to be the proverbial truck coming the other way, you’ll not only be required to avoid panicked selling, but you should be rebalancing your portfolio back to its targeted asset allocation. That will require you to buy stocks (which have been crashing) and selling bonds (which likely have been rising in value).

As Buffett noted, to a large degree, successful investment management depends on your ability to withstand periods of stress and overcome the severe emotional hurdles investors face during bear markets like the ones experienced in 1973-74, 2000-02 and 2008-09.

It's important to note that even though you may have experienced dramatic losses in the past, that doesn't mean that future losses cannot be worse. For example, U.S. investors experienced losses of about 90 percent in the Great Depression. While your plan shouldn’t be based on the worst possible outcome, it does mean that you should have contingency plans, a Plan B, that can be adopted should losses exceed tolerable levels 

There are several issues we need to address to make sure you find the right answer. As always, keep in mind, no one solution works for everyone. 

Far too many investors are subject to the all-too-human trait of overconfidence. It doesn’t matter what the question is: When we asked if we are better than average, about 80-90 percent of people believe they are better than average. While that likely won’t hurt you if you believe that you’re a better than average driver, it can cause you to take more risk than your stomach can actually handle. 

The result will be that when crises occur, your stomach will take over from the head and start making decisions. And stomachs rarely make good decisions. Thus, it’s critical that you don’t overestimate your ability to absorb the stomach acid that bear markets create in all of us.

Don’t lie to yourself (or your financial advisor), as you’re the one that will have to live with the consequences. To help to get this right, think how you were reacting to the most recent crises we faced, including not just the bear market of 2008-09, but the European debt crisis of 2011, and the recent budget and debt ceiling debates and government shutdown — which could easily have led to more crises.

The second issue is that you not only have to pass the “will not panic and commit portfolio suicide by selling during a bear market” test, you also have to be prepared to rebalance by purchasing more equities just when the world looks darkest. But even that’s not enough because you should also be able to pass the “sleep well” test. In other words, if you would be inclined to panic and sell whenever a 30 percent loss in your portfolio occurred, but would be unable to rebalance if losses reached 25 percent, and would start to lose sleep whenever losses reached 20 percent, it’s the "sleep well" level that should drive your decision. Life’s just too short not to enjoy it. 

The third issue relates to a framing problem. Behavioral studies have found that how a question is framed can greatly influence your answer. Consider the following examples from Jason Zweig’s “Your Money & Your Brain.” Each presents the same question, though framed in a different way. Rationally, since the questions are really the same, the answers should be the same. Yet, we find that how the question was framed changes the outcomes considerably, even when experts are asked a question related to their field. 

- One group of people was told that ground beef was “75 percent lean.” Another was told that the same meat was “25 percent fat.” The group that heard about fat estimated that the meat would be 31 percent lower in quality and taste 22 percent worse than the lean group predicted.

- Pregnant woman are more willing to agree to amniocentesis if told they face a 20 percent chance of      having a Down’s syndrome child than if told there is an 80 percent chance they will have a normal baby.

- A study asked more than 400 doctors whether they would prefer radiation or surgery if they became cancer patients themselves. Among the physicians who were informed that 10 percent would die from surgery, 50 percent said they would prefer radiation. Among those who were told that 90 percent would survive surgery only 16 percent chose radiation.

It’s my experience that how the risk tolerance question is framed has a great impact on the answer. To illustrate the point, let’s assume you have a $1 million dollar portfolio. Based on your answers to the “I won’t panic”, the “I will rebalance”, and the “I will sleep well” tests the table provided earlier indicates that the maximum loss you want to face is 25 percent. That translates into a maximum equity allocation of 60 percent. However, if you frame the problem in a different way, it’s likely you’ll get a different answer. The right way to frame the problem isn’t with the use of percentages, but with dollar amounts. With that in mind, now consider the answer from the following perspective.

Assume you begin with a portfolio that is $600,000 in stocks and $400,000 in bonds. Now assume the stock market loses 50 percent and bonds have increased 12.5 percent. Thus, the portfolio is now at $750,000, with $300,000 (40 percent) in stocks and $450,000 (60 percent) in bonds. And now it’s time to rebalance.

To restore your portfolio to your target of 60 percent stocks/40 percent bonds you’re going to have to buy $150,000 of stocks (that have just lost 50 percent and some guru is forecasting it will drop another 50 percent) and sell $150,000 of your safe bonds that actually have risen in value. Will you actually be able to rebalance? My experience is that investors become more conservative when asked the question with dollars as compared to when they’re asked in percentages. Which is why given the importance of the question, the question should be asked in dollars. Otherwise, you’re likely to be overconfident of your abilities. Framing questions in the right way is one way a good financial advisor can add value. 

We need to address one more important point. Returning to our example and the willingness to take risk. If you think you can handle a 60 percent equity allocation level, that doesn’t mean that your equity allocation should be 60 percent. That’s just a maximum. The reason is that you also need to consider your ability to take risk —which we discussed on our last post —  and the need to take risk (determined by the rate of return needed to achieve your financial goal) which we’ll discuss in our next post.

Editor's Notes: Some material for this article was adapted from the author's book, “The Only Guide You’ll Ever Need to the Right Financial Plan.” 

You can try out CBS MoneyWatch's new online asset allocation calculator

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