Risk
How much risk can you actually live with
Every questionnaire asks how you feel about risk. That is the wrong question, asked at the wrong time, in the wrong units. The useful version is arithmetic, it is measured in dollars, and it has an unpleasantly specific answer.
Risk tolerance sounds like a trait, something you either have or lack, like a head for heights. It is not. It is a specific and measurable thing: the largest fall in value you can watch without acting on it. And the only honest measurement anyone has is what they did the last time it happened.
Three different things called risk
Most confused conversations about risk are three separate questions wearing one name. Separating them resolves nearly all of the confusion.
- Risk tolerance
- What you can emotionally sit through without selling. A fact about behaviour, and one that people consistently overestimate about themselves before the first real test.
- Risk capacity
- What your circumstances can absorb, regardless of how you feel. Someone who needs the money in two years has low capacity even with nerves of steel, which is the argument in saving and investing are two different jobs.
- Risk need
- How much risk your goal actually requires. If a modest return gets you where you are going, taking more risk adds the possibility of failure without adding a necessary benefit.
The lowest of the three governs. High tolerance with low capacity is how people end up selling a house deposit at the bottom. Low tolerance with high capacity is how people leave decade money in cash for twenty years, which has its own quiet cost, set out in how inflation affects your savings.
The arithmetic of getting back to even
Falls and recoveries are not symmetrical, and the asymmetry is worse than intuition suggests. A 20 percent fall is not repaired by a 20 percent rise, because the rise starts from a smaller base.
| The fall | 100 becomes | Gain needed to return to 100 |
|---|---|---|
| 10% | 90.00 | 11.1% |
| 20% | 80.00 | 25.0% |
| 30% | 70.00 | 42.9% |
| 50% | 50.00 | 100.0% |
This table is usually deployed as an argument for fear. It is not. It is an argument for not converting a fall into a sale, because a fall on paper is a number and a sale is a decision. Everything on the right hand column is achievable given enough time; none of it is achievable by someone who has left.
Ask the question in dollars
Percentages are emotionally weightless. Nobody has a real reaction to the phrase a 30 percent decline. Convert it to your own balance and the question becomes answerable.
A 30 percent fall on a 20,000 portfolio
- Portfolio before $20,000
- Portfolio after $14,000
- Paper loss $6,000
- That loss, in months of 100 contributions 60 months
Multiplication and division only, not a prediction that any such fall will or will not happen. The last line is the one that tells you something: five years of monthly discipline, apparently undone in a period that might last a few weeks.
Now ask the real question. Looking at that final row, would you keep making the transfer next month. Not should you. Would you. The answer to that is your risk tolerance, and it is worth being pessimistic about, because a plan built on an optimistic answer breaks precisely when it is most expensive to break.
What the split actually controls
The main lever an ordinary investor has over the size of a fall is how much of the portfolio is in shares versus steadier holdings. Here is that lever, in arithmetic, assuming shares fall 40 percent and the rest holds its value.
| Share of portfolio in shares | Portfolio falls by | On 20,000, that is |
|---|---|---|
| 100% | 40.0% | $8,000 |
| 80% | 32.0% | $6,400 |
| 60% | 24.0% | $4,800 |
| 40% | 16.0% | $3,200 |
The cost of the calmer rows is expected growth over decades, which is real and should not be waved away. But a portfolio you actually keep beats a better portfolio you abandon, and that is not a motivational slogan, it is the arithmetic of the previous table applied to a person rather than to a number.
Why the questionnaire fails
Three structural reasons, none of which are about the quality of the questions.
- It is answered on a calm day. Your answer during a quiet Tuesday and your answer during a month of bad headlines are different answers, and only the second one matters.
- It asks about feelings rather than actions. Being comfortable with volatility is not the same as continuing to transfer money into a falling account for eleven consecutive months.
- It quietly measures optimism. People who have never seen a large fall report high tolerance far more often than people who have, and the difference is experience rather than temperament.
A better instrument is history. What did you do the last time something you owned lost a quarter of its value. If you have no such history, assume your tolerance is lower than you think and start where a mistake is cheap, which is one of the arguments for beginning with small amounts in how much money do I need to start investing.
Deciding in advance, in writing
The one technique that reliably helps is embarrassingly simple: write down what you will do, before anything happens, while you are calm.
- The split. What proportion sits in shares, and what in steadier holdings. One sentence.
- The contribution. How much goes in each month, and on what date.
- The response to a fall. Written explicitly. Something like: if the balance falls by a third, I continue the monthly transfer and change nothing.
- The review. When you are allowed to reconsider the split, which should be a date rather than a mood.
That document takes ten minutes and is the closest thing to a defence against your own future reasoning. It is the same document that makes rebalancing possible, as described in how to build a first portfolio. Its value is entirely in having been written before the fall rather than during it.
Common questions
Does risk tolerance change with age?
Capacity changes with age in a fairly predictable way, because the time available to recover shrinks and the money moves closer to being needed. Tolerance changes less predictably. The two are worth reviewing separately rather than assuming one stands in for the other.
Is a bigger fall always a sign of a bigger mistake?
No. Falls are the normal price of holding things whose value is uncertain, and a portfolio that never falls is a portfolio not doing the investing job. The mistake is holding a fall larger than your circumstances or your temperament can absorb.
Should I move to cash if I am nervous?
This site gives no instruction of that kind, and the honest observation is that the decision is nearly always taken at the worst moment. If a written plan already sets out what happens during a fall, the nervous month becomes a matter of following it rather than deciding again.
How do I know my tolerance without living through a crash?
You cannot know it exactly, which is an argument for humility rather than for delay. Starting with small amounts gives you real information about your own reactions while the stakes are low, and that information is more useful than any questionnaire.
All figures on this page are arithmetic used to illustrate a mechanism, not forecasts of any market movement. Nothing here is a recommendation about how to allocate a portfolio, and no allocation on this page should be read as a suggestion.