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By Christine Benz and Jason Stipp | 08-16-2012 01:00 AM

Rethinking Risk Tolerance

Investors should redefine their risk tolerance in terms of their actual risk capacity instead of their ability to stomach short-term volatility

Jason Stipp: I'm Jason Stipp for Morningstar.

Recent volatility over the last few months--and over the last few years, really--has put a special emphasis on investors' so-called "risk tolerance."

But Morningstar's Christine Benz, director of personal finance, says there are pitfalls to relying solely on risk tolerance to guide your portfolio decisions. She's here to offer some tips on that.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: "Risk tolerance" is a phrase that comes up quite often when you're talking about portfolio planning or putting a portfolio together. There are risk tolerance questionnaires that people fill out. What are they trying to get at with risk tolerance, and what are some of the shortfalls there?

Benz: Well, usually when you see risk tolerance questionnaires, what they are trying to get at is an investor's ability to withstand short-term losses, or oftentimes it's stated in terms of, can you sleep at night with this level of losses? So, people are asked to look at losses of certain magnitudes and see if that's something they have a comfort level with.

So usually when you hear about risk tolerance, it's framed in terms of your psychic ability to handle a certain level of loss.

Stipp: So, it's kind of a tolerance for the volatility of the market that we may see in shorter time periods--especially swings down, I think, is how they are defining that risk tolerance.

Benz: They are, and you asked, Jason, about the pitfalls of focusing too much on risk tolerance, and when you think about it, the big pitfall is that you're essentially letting your gut drive part of your decision-making, and there's been this whole field of behavioral finance that has cropped up with very valuable research about how investors oftentimes undermine their own investment results by letting their guts do the driving.

So, I think by placing too much emphasis on your risk tolerance and how you feel about losses, particularly short-term losses that you may be able to recover from, I think you risk running with an overly conservative portfolio, given your time horizon and the years until the time when you'll actually need your money.

Stipp: So, if people want to sleep well at night, they might move to shorter-term investments, or fixed income or something like that, because that's not going to be as volatile. But actually, in some ways, if they do that, then they are running another kind of risk, which is that they are not going to earn enough.

Benz: Shortfall risk. And to me, when people are thinking about risk tolerance, I would stretch out the time horizon, even though a lot of the surveys you might see, or the questionnaires about risk tolerance, might focus on, if you lost 10% in a week, how would you feel?

I say, lengthen your time period and look at how you would feel if you were coming into retirement and it looked like you were going to fall short; it looked like your only levers left would be to continue working longer, or if you did go ahead and retire at the age of 65, could you get by with a much lower income than you expected to have, or would you be comfortable asking your kids for help? So stretching out the time horizon by which you gauge risk tolerance, I think, can be a really valuable exercise.

Stipp: And measuring it as the percentage chance that you would have a shortfall of 10% or 15% or 20% or more, and how comfortable are you with that? And then that guides your asset allocation decisions in a much different way, right?

Benz: Exactly, so a lot of asset allocation tools that might use Monte Carlo simulations would actually show you the probabilities of you actually being able to hit your intended goal during retirement [given your savings rate, current savings, and asset mix].

Those can be really useful, and if you're not within a reasonable probability of hitting your goal, maybe it's time to step back and rethink the way that you are asset allocating, and your savings rate, and so forth.

Stipp: So Christine, we're kind of talking about another concept that we've raised before that's ancillary, or complementary, to risk tolerance, and that's risk capacity--in other words, how much risk can you actually take on?

So if you know you have a longer time horizon, for example, that should inform the kinds of risks that you take. It's much different than if you have a very short time horizon and your capacity for risk is obviously different, then.

Benz: Exactly. I see risk capacity as actually being a much more important concept for people who are putting together their portfolios, and the reason I see it as more important is because it focuses on your actual ability to withstand losses in your portfolio.

So if you are someone with, say, only seven years until your desired retirement date, you literally cannot withstand losses of 35% in a total portfolio that consists entirely of equities at that point. You wouldn't be able to make that back before you need to start drawing upon your portfolio.

So I think risk capacity really should be a much more important concept for investors, and they should use it to inform their risk tolerance. So, if you are a 32-year-old and you know that you have 30 more years, you have a very long risk capacity--you have great risk capacity--you should also have great risk tolerance.

Stipp: So, it's easy to say you have the time to make up for losses or to weather volatility, but we do know that investors can be very emotional and sometimes that can lead them to make mistakes.

So if you're an investor, let's say, where there is a mismatch, and let's say that your theoretical capacity for risk is quite large because you have many, many years, decades, until you retire. But let's say you've been through this last bear market, and you're maybe in your late 20s or early 30s, and you lost a good bit of the value of your portfolio, and you're not feeling like you're very risk tolerant, even though you theoretically have the capacity to do it.

What are some steps you can take in order to make sure that risk capacity is really taking the lead here?

Benz: A couple of things I would think about. One is, within asset classes like equities, focus on more conservative investment types. Look for risk-averse fund managers who really do put a big emphasis on limiting downside, limiting losses. So, if that will help you, that's one idea.

Another is just recognize that if you are running with a conservative portfolio--and frankly, I think that's a pretty risky thing to do these days if you have a very long time horizon, because I think most people would say bond returns are apt to be pretty muted in the decades ahead--recognize that you are going to have to do more of the heavy lifting in terms of your own savings rate. [Your savings rate] is going to have to make up for the fact that you won't have as much in equities working for you and potentially earning a higher return.

Stipp: So, Christine, what about on the other side, where, let's say, someone in their late 50s or early 60s feels like they haven't saved enough and they want to take on more risk and be more aggressive in order to make up for lost ground, even though their risk capacity is much lower than it was when they were younger. How would you advise someone like that?

Benz: That's a really common profile. For that person, too, I would say that making sure that adding, making additional contributions, making greater-than-average contributions, would be part of the prescription. So would beginning to think about situations where you might be able to extend your working years a little bit longer--maybe through some part-time work or consulting work or whatever it might be--that's another thing you could think about in lieu of having a terribly risky portfolio.

And finally, I would say for people who think that they need to have a high risk tolerance and they need to run with a very risky portfolio, an important thing to keep in mind [and] one thing we find is that people overestimate their risk tolerances when the market is relatively good, and it has been pretty good over the past three years. And then they really pull in their horns when things go bad, and they might be inclined to dump everything and switch to a more conservative mix at what, in hindsight, could be an inopportune time.

Stipp: And that's when risk capacity really comes to bear. If they have big losses in that overly aggressive portfolio and they are close to needing the money, they are even more likely, I think, to let risk tolerance take the reins there and cause them to sell when the market is maybe at a trough.

Benz: Right, and the sad part about that--and we saw that all too much in the latter part of this past decade--was the tendency to turn those paper losses into real losses.

Stipp: And lock them in.

Christine, it sounds like two very important concepts in a multifaceted topic of risk. But let risk capacity lead the way, and you should be able to get a portfolio--you might have to ride out some rough spots--but you should be able to get a portfolio that stacks the deck in your favor.

Benz: I think so. Thank you, Jason.

Stipp: Thanks for joining me.

For Morningstar, I'm Jason Stipp. Thanks for watching.
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