Updated May, 2020

Asset allocation and your risk tolerance

risk safety scales

Now we understand that we can’t just put all our money into fixed-term deposits if we want to live off our assets for a decades-long retirement. To get a higher return, we will need to take some risk, and we need to know what the considerations are for deciding how much risk to take.

Risk tolerance is your ability to tolerate market swings, and it’s very individual.
These are some of the main factors in identifying your risk tolerance.

  • The younger you are, the higher your risk tolerance. You have decades of future income to save and recover any losses, and you have time to let the market recover from any short- and medium-term declines.
  • The less wealth you have relative to your retirement goal, the higher your risk tolerance. Losing half of $50,000 is not the same as losing half of a million-dollar nest egg.
  • On the other hand, if you have way too much, such as from a massive inheritance, you can tolerate higher risk due to such low relative needs allowing you to avoid significantly depleting your portfolio during market declines.
  • The more secure your job, the higher your risk tolerance as you have a more secure income and less need to tap into your investments.
  • A double-income couple has a higher risk tolerance due to multiple sources of income.
  • Having dependants lowers your risk tolerance. If you lose your job and need to draw from investments, the need to draw larger amounts when the market is down will mean you lose proportionately more than drawing from a larger risk-free portion of assets allowing the market to recover.
  • Having other sources of secure income increases your risk tolerance. A guaranteed pension, annuity, or investment property in high demand locations will mean you can take on more risk with your remaining investments.

A 25-year-old with $50,000 to invest, no dependants, and decades of future income to make up losses is going to be able to tolerate a lot more risk and therefore get a higher expected return than a 50-year-old who has spent their life saving up a million dollars, only has ten years to save and recover losses, who has three kids depending on them financially and is in a job that is not secure.

A retiree who cannot work to save and recover market losses will have an even lower risk tolerance. However, if they own their home outright and have purchased an inflation-adjusted annuity to cover their basic cost of living for the rest of their life, they may well have a high risk tolerance for the rest of their funds.

Your risk tolerance also depends on your ability to tolerate seeing the value of your investments drop without panicking. Someone who sees their investment decline by 50% and reacts by wanting to buy more when stocks are cheap has a high risk tolerance, whereas someone who sees the value of their investment fall by 20% and worries and starts thinking of pulling out of their investment has a lower risk tolerance. Fear during dips in your investment can also be due to a lack of education in the nature of the stock market.

How to adjust your investment based on your risk tolerance

We will adjust our assets up or down the risk-reward spectrum by adjusting our asset allocation (AA) of stocks to bonds.

Someone with 100% stocks will be way up the top end of the spectrum, someone with 100% bonds will be way down the other end of the spectrum, and everyone else will be somewhere in the middle.

A 25-year-old would generally have mostly stocks to match their higher risk tolerance, whereas a 70-year-old retiree would usually have mostly bonds to match their low risk tolerance.

What are some guidelines that people use to determine their equities to bonds allocation?

Age-based allocations

The most widely cited guideline is the “age in bonds” rule. If you’re 35, that would suggest an asset allocation (AA) of 65/35, which means 65% in stocks and 35% in bonds. As you get older, you would increase your allocation to bonds, lowering the overall portfolio risk. The reason is that as you age, you tend to run out of years to be able to accumulate more wealth from working, tend to have a larger nest egg to protect, and less time for the market to recover any losses.

Notice how you’re using the safe asset proportion (bonds) as a tuning dial for your overall portfolio risk level. As your risk tolerance reduces over time, you increase your proportion of safe assets to where you would like your portfolio to sit on the risk-reward spectrum.

Many find the age-in-bonds rule too conservative, especially during the early stages of accumulation, particularly those below 40. To overcome this, some people change it to age-minus-10 or age-minus-20. So, for a 30-year-old, this would suggest an allocation of 10-30% bonds (90/10 or 80/20 or 70/30). Age-minus-10 seems like a good middle ground starting point.

Another age-related allocation strategy is to have little or no bonds (other than for an emergency fund) until about 20-25 years from retirement and then glide up by adding 2% more bonds each year until you get to your desired 40-50% bonds at retirement. This more closely matches the asset allocation glide path of target date funds available in other countries where you’re put in a 90/10 portfolio until around the age of 40 before a glide up in bonds begins.

While the “age-in-bonds” rule is a reasonable starting point for the average of the population, unfortunately, it ignores all the considerations listed above. One 35-year-old could have just started saving and have no dependants, while another could have been saving for 15 years already, be a single earner with a family of dependants in a high-risk job and have a large mortgage. These considerations should help you get an understanding of your personal risk tolerance.

Goal-based allocation

Another option is to set your asset allocation (AA) to how far you have progressed to your goal. For example.

% of targetAA
40 – 80%70/30
80 – 90%60/40

For a linear percentage-of-target formula, first, decide on your retirement goal amount and then on your retirement target allocation. Then your current AA would be your current percentage of the way to your retirement goal multiplied by your retirement target allocation.

For example, if your goal is $1,000.000 and your desired retirement allocation is 40% bonds when you get there, that would come out to the following.

% of target bond allocation AA
$200.00020%20% x 40% = 8% bonds92/8
$400.00040%40% x 40% = 16% bonds84/16
$600.00060%60% x 40% = 24% bonds76/24
$800.00080%80% x 40% = 32% bonds68/32
$1,000.000100%100% x 40% = 40% bonds60/40

The percentage-of-target based allocation is a step up from the basic age-in-bonds idea, but can also be lacking. For instance, if you started saving and investing late or just had a bad period in the markets and ended up at 50 years of age with just 30% of your goal, 70/30 may well be far too risky for you. Another problem is if you’re in your 50’s and only two-thirds of the way to your goal and there’s a fundamental change in your industry, and you’re forced into early retirement. In both cases, you may need to adjust your target to something that is more realistically achievable.

A combination of goal-based allocation and age-based allocation is a good start, but you should take all your circumstances into account when deciding on an asset allocation, including age, time until desired retirement, progress to retirement goal, job security, health, and so on.

A more comprehensive guide – determining your ability, willingness and need to take risk

Here is one of my favourite asset allocation articles, by Larry Swedroe.
Asset Allocation Guide: Dealing with conflicting goals
Be sure to click on the links to ability, willingness and need to take risk explained in there.

In summary –

Your ability to take risk depends on your ability to leave your money invested.
If you are decades from retirement and will then draw down slowly over decades more, your ability to take risk is high.
If you have begun your distribution phase at say 65, your ability to take risk is much lower.
Although if you have other secure sources of reliable income such as a pension, annuity, or investment property, then your ability to take risk with your stocks is going to be higher.
A common mistake people make is assuming they can be fully employed continuously for 20 to 30 years. People have different levels of ability to take risk depending on whether they can remain continuously employed versus the possibility of becoming temporarily or permanently unemployed or under-employed, especially after hitting their 40’s and 50’s. If you lose your job and become permanently unemployed in your profession, can you survive for five years without selling any stock? Major drawdowns are one thing, but it’s not uncommon for the recovery to take a lot longer than it did during the GFC.

Your willingness to take risk is your ability to stay calm during times of high volatility – when the stock market takes a dive.
To do this, you imagine how much money you can tolerate seeing your overall investment drop by, and have no more than double that in stocks – and put the rest into bonds.
For example, say you had $750,000 and could tolerate it dropping to $500,000 but would panic-sell once it got below that point – you would put double the $250,000 maximum tolerable loss into stocks ($500,000), and the remaining $250,000 into bonds. Then in a severe bear market where the stock market drops by 50%, half of your stocks have dropped in value, but your safe assets have not, so your overall $750,000 has fallen only 33% down to $500,000 while the broader stock market has dropped by 50%. The goal is to plan for a maximum drop to where you can continue to tolerate it and leave it invested to recover, rather than panic-selling and crystallising your losses, making them permanent.

Your need to take risk is the return you require your investments to make to meet your goals.
This is calculated mathematically.
Let’s say you’ve determined that a historically safe yearly withdrawal rate of your assets for 30 years was 4% of your assets, and your income needs (beyond any other income sources such as a pension, annuity, investment property) were $40,000 per year – then you would divide the $40,000 by the 4% leaving you with a need of $1,000,000.
You then would build a simple spreadsheet based on current portfolio value, regular contributions, expected return based on the stock-to-bond ratio (more bonds means lower expected return). You could then determine how many years you would need to reach your savings goal based on your income needs. If you could not meet it by retirement age, you have a need to take more risk to reach your goal.

Note that there are other means to lower your need to take stock market risk – by increasing your savings rate, increasing your accumulation time horizon (delaying retirement), or reducing your planned retirement spending.

The most important decision you’ll make in your portfolio is your stock-to-bond allocation. Too low a proportion of stocks to bonds and you risk your portfolio not meeting your needs. Too high and you run the risk of panic-selling in a crash ensuring permanent loss, or the risk of drawing down equities at a lower price in an extended bear market where you deplete your portfolio faster and for longer. Frustratingly, it’s impossible to get an exact figure, but hopefully, the above guidelines help you get an idea of where your risk tolerance is.

Some more links that may be helpful
How to estimate your risk tolerance – Monevator
Asset allocation – Bogleheads