Author Topic: "Sleep at night" risk tolerance measure isn't sufficiently specific  (Read 3470 times)

mustachianism_is_aredpill

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I have a problem with the way practically every single asset allocation article (for example, http://www.cbsnews.com/news/asset-allocation-guide-what-is-your-risk-tolerance/ , which I found linked from the Bogleheads asset allocation page) frames the question of how much risk you are prepared to bear: Will this level of risk let me sleep well at night? I can understand this is useful for retired folks, because all their income comes from market performance.

I, however, find it impossible to determine how much risk I should take on based on this yardstick. Because I currently have a job, I don't fear market fluctuations at all. As long as I have my job, I can pay for food and shelter; markets taking a small dip are a bonus because investing is cheaper.

If the big one (like 2007-2008) hits the markets again, I will be SOL because my job may be gone and so will a good chunk of my portfolio. On the other hand, the markets have only been going one direction my entire working life (post 2008), so I am a "summer child" if you will. I am intellectually aware that bad times will come again, but having never lived through them, I don't know how it will actually be. If I keep my job, I'll have a ball because everything (stocks, housing, gas, travel) will be cheaper. If I don't, all bets are off. Either way, the actual state of the market is (mostly) irrelevant.

I guess the question I want to ask is this: is there a better way to determine your risk tolerance level (and therefore, asset allocation), beyond "sleep at night"? It's not a useful way to frame the problem, particularly for inexperienced investors like myself. Preferably something more mathematical, taking into account factors like "likelihood of job loss".

deborah

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Re: "Sleep at night" risk tolerance measure isn't sufficiently specific
« Reply #1 on: November 30, 2014, 03:18:29 PM »
Sleeping at night was my criterion even when I was your age, well before I retired. I would wake up in the middle of the night and wonder how I would cope if I lost my job tomorrow - how would I pay my bills, was my rent more than I could cope with on unemployment benefits... And when I got a mortgage, and mortgage interest rates were 18%, and inflation was high, and unemployment rates were high, I would wake up and wonder whether I could cope if I lost my job. But then, when I was young, unemployment WAS high. And, I guess I was a born pessimist. Maybe I woke up enough for both of us.

If you sleep soundly, maybe you should just do some what-ifs.

matchewed

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Re: "Sleep at night" risk tolerance measure isn't sufficiently specific
« Reply #2 on: November 30, 2014, 03:22:32 PM »
No there really isn't, because what is meant by "Sleep at night" is what sort of risks are you willing to take without reacting in an emotional manner. That is regardless of whether you are a retired person, saving for FIRE, or anything else. Basically if you can't handle the risks of an investment you should not be in it. Handling goes for understanding and emotional reaction towards it.

Thinking of risk solely in terms of amount is the wrong way to view risks even if they are communicated in that manner. Risks aren't only "how much" they also are "what type" and "how frequent". The "how much" of your risk is only in whether your money is in some way protected, FDIC for example. In theory anything beyond savings accounts has a potential "all of it" answer to the "how much" question. What you should try to understand is what are the risks, how frequently do they occur, how severe the downside is if they happen. If you can grasp that and know that the potential return is acceptable while considering those risks, then the investment may be for you, or at the least it is suited for your risk tolerance.

You may not have practical experience with a market crash but consider how you'd react to one and worse case scenarios happened. What could you do to mitigate those bad things? Those are the things you should be preparing for now. Job loss? Increase your skill sets. Monetary loss? Ensure that you have a high savings rate. House loss? Social network (not the facebook friend kind the real friend friend kind).

There is no mathematical formula. This will have some component of "gut" feeling because you don't want to have a gut reaction to a situation. You want to have thought of it beforehand so that you at least have a rough plan for what to do when it does hit the fan.

sol

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Re: "Sleep at night" risk tolerance measure isn't sufficiently specific
« Reply #3 on: November 30, 2014, 03:43:50 PM »
That "sleep at night" risk tolerance just means that you won't sell low.  Would you sell assets if they halved in value, or would you buy more?

When the market tanked this last time and our portfolio nosedived, it never even occurred to me that we might want to sell.  Why would we lock in losses after a huge crash?  Better to grit your teeth and keep buying through the slaughter, knowing you'll come out better on the far side.

So just commit to buying into the market regularly, every paycheck, for the rest of your working life no matter what happens.  There will never be a time when you will know ahead of time that you would be better off postponing this paycheck's investment contributions, even when you think it's totally clear.  You'll be wrong more than half the time, so just keep buying.  If you think you're rational enough to do that, then don't worry about being pressured into "safer" asset allocations.

Two years ago on this very subforum, people were calling the top of the bubble, saying things like "the market has risen too far too fast, I'm 100% cash until the coming crash is over.  Since then the market is up like another 50% and those people (hi y'all!) are kicking themselves.  We heard the same thing last year, and again this October.  As if every momentary pause heralds a market correction and quick, everyone buy gold!  Wrong again. 

Which just goes to show you that being too risk averse costs you just as much as taking on too much risk.  Better to stick to the plan through thick and thin, whatever that plan is.

wtjbatman

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Re: "Sleep at night" risk tolerance measure isn't sufficiently specific
« Reply #4 on: November 30, 2014, 08:54:45 PM »
Benadryl helps me sleep at night. That's probably why I'm ok with a 100% stock portfolio.

Khan

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Re: "Sleep at night" risk tolerance measure isn't sufficiently specific
« Reply #5 on: December 01, 2014, 04:58:02 AM »
Quote
If the big one (like 2007-2008) hits the markets again, I will be SOL because my job may be gone and so will a good chunk of my portfolio.

Define big one. The biggest ones we can look at, historically, are something like 30-50% haircut, followed by stagnant "real" returns on the order of [worst case] 15 years. If you had invested on the day before the market crashed in 1929, you would have been back in the black on real return in 15 years(Stocks for the Long Run).

Yes, losing your job would suck, and that's why you should have money set aside in a variety of investment vehicles(taxable, ROTH, pre-tax) to allow yourself to survive those layoffs for a while, to move yourself wherever the job market might be greener. That's part of why the question of emergency funds is important on a personal level. I'm comfortable with margin credit and credit cards, it let's me sleep at night, that might not be the case for others. OTOH, in the end, we all die. An asteroid hits the earth(or the dollar collapses, or nuclear some such, fill in your apocalypse here ____), and it wouldn't matter what your net worth or FIRE plans are/were.

So, combining the two sentiments, in a "worst case scenario", in which the sky doesn't fall, but bad things happen, will you kick yourself in the teeth and make things worse, or will you grit your teeth, smile(because you're decently positioned for any eventuality), and pull through?

Does your stock/bond/international exposure have you following the market religiously on a daily basis? Are you causing yourself stomach ulcers and other issues, or, can you sleep soundly? In a 30% down market, will you be able to smile at all the blood in the streets, and raise your hand with a couple hundred dollar bills in it and yell out "Buy buy buy!"?

I'm 27. I'm very employable(veteran, electronics technician/operator). I have 3 years of GI bill benefits left to use up, and I'm decently employed right now to boot. I can't project a 5 year scenario in which I end up on the other end of it crying on the streets because of my choices in life, lamenting my decisions, my allocations, any of it. Any scenario that is that terrible for me after 5 years is a nuclear winter grade level of calamity, and there's just nothing I can do to plan for that.

I sleep like a fucking baby.

Also, +1 point to sol.

ScroogeMcDutch

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Re: "Sleep at night" risk tolerance measure isn't sufficiently specific
« Reply #6 on: December 01, 2014, 05:33:03 AM »
I agree with the others - it's going to be hard to quantify the amount of risk you as an individual are willing to take that will let you sleep well at night.

I have only started investing this year (at 34 years old) so I do not know exactly what a nosedive of the market will do to my mindset either. I did see the 2008 collapse happen though, and thought the world as we knew it was coming to an end, and I didn't exactly feel like investing at that point (nor did I have the resources to do so).

By now I have read up and was searching for yield on my savings. I am still conservative compared to many here ( about 65% stocks, 5% bonds, 30% cash - the cash as I am also saving to buy a house, so in time that will change to the house-I-live-in-asset). I did watch the 10% decline in October with a bit of dread, thinking I got in at the top.

So in part it was getting into the game, watching the game, and observing my reactions to game at the time, that gave me an idea of my risk tolerance. I could tolerate a 30% drop in net worth, as long as that drop would not affect (effect?) my day to day life. As I work as a contractor in a field which has had quite a strong correlation with the economy as a whole, a market drop would also likely mean my income drop dramatically.

hodedofome

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Re: "Sleep at night" risk tolerance measure isn't sufficiently specific
« Reply #7 on: December 01, 2014, 08:45:39 AM »
No there really isn't, because what is meant by "Sleep at night" is what sort of risks are you willing to take without reacting in an emotional manner. That is regardless of whether you are a retired person, saving for FIRE, or anything else. Basically if you can't handle the risks of an investment you should not be in it. Handling goes for understanding and emotional reaction towards it.

Thinking of risk solely in terms of amount is the wrong way to view risks even if they are communicated in that manner. Risks aren't only "how much" they also are "what type" and "how frequent". The "how much" of your risk is only in whether your money is in some way protected, FDIC for example. In theory anything beyond savings accounts has a potential "all of it" answer to the "how much" question. What you should try to understand is what are the risks, how frequently do they occur, how severe the downside is if they happen. If you can grasp that and know that the potential return is acceptable while considering those risks, then the investment may be for you, or at the least it is suited for your risk tolerance.

You may not have practical experience with a market crash but consider how you'd react to one and worse case scenarios happened. What could you do to mitigate those bad things? Those are the things you should be preparing for now. Job loss? Increase your skill sets. Monetary loss? Ensure that you have a high savings rate. House loss? Social network (not the facebook friend kind the real friend friend kind).

There is no mathematical formula. This will have some component of "gut" feeling because you don't want to have a gut reaction to a situation. You want to have thought of it beforehand so that you at least have a rough plan for what to do when it does hit the fan.

This is it. Buffett's quote tells the whole story: Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people in trouble investing.

IMO, as Matchewed said, the way to control your emotions is to first look at the historical returns, volatility and risks of your investment. And don't look at it as an average over the past 50 years..., look at each year, and look at what happened that year. It also helps to have historical context of what was going on in the economy during that time. What would you have done when stocks dropped 50%, unemployment shot through the roof, and every day the news was morbid? You need to work through those scenarios and be honest with yourself. Observing (IN DETAIL) what happened in the past (go back 100 years or more), is going to give you the confidence and conviction you need to stick with your plan for the future. Even though the future isn't going to be exactly the same, it is going to be similar enough. Humans control the market and human nature doesn't change on the average. What's going to happen in the future has happened before, to somebody, to some country. You may need to look back 300 years in Finland but the similarities are there.

I'll also add that many people will need to go through some personal counseling with themselves to deal with their emotional shortcomings. Even if you've studied everything, if you have some sort of fear or greed issue you'll need to deal with that. The problem will not be the market, the problem will be YOU. You will have to go through the difficult work of dealing with your past failures and issues so that you can invest without fear and greed. This is not something to sneeze at. How many people can honestly say they can invest without fear? But it's possible, and it's worth pursuing. Not only will you become a better investor, you'll probably become a much better person through the process as well.

AJDZee

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Re: "Sleep at night" risk tolerance measure isn't sufficiently specific
« Reply #8 on: December 04, 2014, 09:14:53 PM »
It sounds to me like you have a high risk tolerance. Both from what you're saying about knowing market risks as well as it sounds like you're early in your career.

Might be more a question of an emergency fund - would you be comfortable with an aggressive asset allocation if you had enough cash in high-interest savings account so that you can pay your bills for a period of time (6 months for example)?

I can understand needing more objective process to make the decision - so run a scenario that represents 'worst case' of being laid off. Are you happy with your coverage? Run a 'most likely' scenario (everything is just fine and avg returns), are you happy with the potential returns?

If answers to both are yes id say you're where you need to be
« Last Edit: December 05, 2014, 12:57:23 PM by AJDZee »

mustachianism_is_aredpill

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Re: "Sleep at night" risk tolerance measure isn't sufficiently specific
« Reply #9 on: December 13, 2014, 03:51:34 PM »
Thanks for the replies everyone.

I did a review of all my holdings. I realized I wasn't almost 99%-1% stocks-bonds as I had previously thought (which is what caused this bout of portfolio introspection), because I had failed to take into my retirement accounts. Counting those, I'm closer to 88-12, which various rules of thumb say are right for my age and stage of career.

Again, I don't fear the market going down a little bit, say 5-10%. I slept like a baby (with a little smile on my face) when we had that dip mid-September. What I fear is a big downturn; the kind that leads to layoffs and cost-cutting across industries because my job is dependent on ad spending.

LordSquidworth

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Re: "Sleep at night" risk tolerance measure isn't sufficiently specific
« Reply #10 on: December 13, 2014, 07:52:11 PM »
I have a problem with the way practically every single asset allocation article (for example, http://www.cbsnews.com/news/asset-allocation-guide-what-is-your-risk-tolerance/ , which I found linked from the Bogleheads asset allocation page) frames the question of how much risk you are prepared to bear: Will this level of risk let me sleep well at night? I can understand this is useful for retired folks, because all their income comes from market performance.

I, however, find it impossible to determine how much risk I should take on based on this yardstick. Because I currently have a job, I don't fear market fluctuations at all. As long as I have my job, I can pay for food and shelter; markets taking a small dip are a bonus because investing is cheaper.

If the big one (like 2007-2008) hits the markets again, I will be SOL because my job may be gone and so will a good chunk of my portfolio. On the other hand, the markets have only been going one direction my entire working life (post 2008), so I am a "summer child" if you will. I am intellectually aware that bad times will come again, but having never lived through them, I don't know how it will actually be. If I keep my job, I'll have a ball because everything (stocks, housing, gas, travel) will be cheaper. If I don't, all bets are off. Either way, the actual state of the market is (mostly) irrelevant.

I guess the question I want to ask is this: is there a better way to determine your risk tolerance level (and therefore, asset allocation), beyond "sleep at night"? It's not a useful way to frame the problem, particularly for inexperienced investors like myself. Preferably something more mathematical, taking into account factors like "likelihood of job loss".


That's what your emergency fund or cash cushion is for.

In the event the market collapses, and you lose your job... you should have a cash pile somewhere to mend the gab between finding a new job/portfolio recovers. If you keep your job and the portfolio goes down, you have some cash to buy discounted stuff.