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Full Version: Is Taking Risk Necessary?
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The ability to take risk
Swedroe says your ability to take risk depends on your investment horizon and the stability of your income (or human capital). If you’re 25 years from tapping your savings, or if you’re a senior public servant, you can keep a large portion of your portfolio in stocks. If you’re three years from retirement, or if you’re a commissioned salesperson, you should hold a far greater proportion of fixed income investments.
Swedroe offers these guidelines when considering the right equity allocation for your investment horizon. You can increase or decrease these suggestions based on your income security:
Your investment Maximum equity
horizon (years) allocation
0–3 0%
4 10%
5 20%
6 30%
7 40%
8 50%
9 60%
10 70%
11–14 80%
15–19 90%
20+ 100%
The willingness to take risk
How likely are you to panic when your portfolio loses value, as it inevitably will? Is a 25% drop going to give you ulcers? The willingness to take risk depends on your psychological makeup. Advisors give their clients risk-tolerance surveys to measure this willingness, but these are only worth so much. Only real-life experience — and we just had a litmus test in 2008–09 — will determine how big a loss you can truly tolerate.
Here’s Swedroe’s guidelines for determining a portfolio’s equity allocation based on the degree of loss you can accept without hurling yourself out the window:
Maximum loss Maximum equity
you’ll tolerate allocation
5% 20%
10% 30%
15% 40%
20% 50%
25% 60%
30% 70%
35% 80%
40% 90%
50% 100%
The need to take risk
Finally, all investors should consider their need to take risk. If your financial plan suggests you’ll need a 7% annualized return for 20 years to retire comfortably, you’ll need a significant allocation to stocks. But if you’ve saved enough money to meet all of your financial goals, you might forgo all market risk.
Quote:Swedroe tells the story of a couple in their 70s who had saved $13 million, only to lose $10 million by investing it all in tech stocks. The couple admitted that if their portfolio had doubled, it would have had no effect on their lifestyle or happiness.
. Why, then, did they put all that money at risk for no reason?
Swedroe doesn’t match specific asset allocations to target rates of return, which is smart, since no one can predict what the markets will give us in the future. However, in a previous post, I included a table of returns for different stock-bond mixes since 1970. Vanguard also publishes historical returns for several portfolio mixes going all the way back to 1926.
You may be surprised to see that a simple 50–50 portfolio has delivered long-term returns between 8% and 10% annually (depending which indexes you use and how often you rebalance). How many people need returns higher than that to achieve their goals? If you take more risk than that, make sure you have the ability and the willingness to stick to your plan.