Asset Allocation: How Much Risk Are You Willing to Take?

Now that you have determined how much risk you need to take, and how much risk is wise for you to take, the final step is determining how much risk you are willing to take.

Some people are naturally adventurous.  They seek out and thrive on risk.  Others are naturally more cautious, avoiding risk when possible.  Should your feelings towards risk be considered when deciding how much of your money to expose to the stock market?  Some financial experts believe it should while others feel that if you need to take risk, and it would be smart for you to take risk, then (gosh-darn-it) you should take risk, whether you want to or not.

The latter view is expressed by Phil DeMuth in his book The Affluent Investor: Financial Advice to Grow and Protect Your Wealth, where he writes:

“Your psychological predisposition to take or shun risk is irrelevant to the ultimate means to reach your investment objectives. This would be like a doctor saying that your psychological preference to wear or not to wear a cast should be an important factor in evaluating how to treat your broken arm. You should invest in the way that has the greatest prospect to fulfill your investment goals. That might mean taking more or less risk than you would prefer. If you are a sensitive soul who can brook no paper losses, the solution is to get a grip, not to invest ‘safely’ if that locks in running out of money when you are old. A timid librarian might require a manly asset allocation to reach her goals. A motorcycle daredevil might need to be in bonds to reach his.”

I think a different analogy from the medical profession better fits the investment risk decision. Instead of having a broken arm, imagine you are a significantly overweight couch potato who goes to the doctor for a physical examination. The doctor informs you that you have high blood pressure, high cholesterol, and pre-diabetes, and that you are headed for serious health problems unless you make some significant lifestyle changes.

The doctor could mandate a very strict diet and strenuous exercise program. That is, after all, what you need to improve your health, and it would definitely be wise. If you protest, the doctor might tell you to “get a grip” and follow his orders whether you want to or not.

What would be the likely result of the doctor’s mandate? You might be scared enough to stick with the plan for a short time, but when things get tough, as they surely will, and with the doctor not there to constantly monitor you, you will probably begin to fall back into bad habits.

Unlike the example of the cast, which is difficult to remove once it is on, the diet and exercise program requires continuous commitment on your part. Each day you have to decide again if you will follow the plan. If the plan is more stringent than you are willing to commit to then you might begin to ignore it completely, and you could end up in worse shape than when you first went to the doctor. The doctor would be better off to work with you in designing a diet and exercise program that, while not perfect, would be something you could stick with over the long term.

The diet analogy is much closer to the situation faced by investors. What you should do is important, but so is what you are willing to do. Like the dieter who falls of the wagon and ends up weighing more than before the diet began, the worst thing an investor can do is take more risk than they can maintain. The result is usually panic selling when the market drops. Do this several times and you will have no chance of reaching your financial goals. The key is to design a plan you can stick with over the long term, and to do this you need to consider how much risk you are willing to take.

Advice from J.P. Morgan

I admire people who can impart wisdom using only a few words. J.P. Morgan, famous American businessman and philanthropist, possessed this talent. When Morgan was asked what he thought the stock market was going to do in the future his three word answer was, “It will fluctuate.”

Another time a friend came to him seeking investment advice. His friend reported having trouble sleeping because he was so worried about his stocks. This time Morgan’s answer took six words. His wise advice was, “Sell down to the sleeping point.”

Since the market will continue to fluctuate, and since we all need sleep, determining your own personal “sleeping point” (an asset allocation you can stick with no matter what the market does) should certainly be a consideration when deciding how much investment risk to take.