How will you spend your tolerance for risk?
Tim Maurer, Director of Personal Finance, The BAM Alliance
“I just really wish I’d taken more risk in my investment portfolio,” said no one–ever–on their deathbed.
That may seem like an odd observation, unless you consider the fact that I had the privilege of spending a couple days recently with life planning luminary George Kinder. Among other benefits, I was able to reacquaint myself with his famous three questions, elegantly designed to progressively point us toward the stuff of life that is the most important–to us.
The final question invites us to explore what benchmark life experiences we would leave unaccomplished if we only had one day left on this Earth. And as you may suspect, even in a room filled with financial planners, achieving a more aggressive portfolio posture was, perhaps, the farthest from anyone’s mind.
Meanwhile, most of the items that people did list represented experiences (not things) that, individually, were outside of their to-date unarticulated–but now evident–comfort zones.
Participants almost universally wished they’d have taken more risks in life–personally, educationally, relationally, experientially, professionally and vocationally.
Similarly, those most meaningful experiences they had enjoyed thus far in life were the ones that pushed the boundaries of their comfort zones, expanding their personal risk tolerance.
But what about financial risk tolerance?
It’s now been well established that humans generally make poor investment decisions. The field of behavioral finance and economics has helped explain why:
Yes, we each have a unique tolerance for risk, but regardless of how full our risk reservoir is, it is still an exhaustible resource. Therefore, the more risk you’re taking in your portfolio–the more volatility that you are enduring and the more resolve you’re expending to stay the course–the less risk you have to spend on the rest of your life.
There are those in my field who’ve made it their life’s work to convince investors of the benefits of risk-taking in investing. And to be clear, those benefits have proven, historically, to be real. Those who take more risk in investing–strategically, mind you, not haphazardly–may justifiably expect to receive greater rewards from their investment portfolio over the long-term.
But at what cost? How much risk tolerance did you have to expend to endure losing at least half the value of your aggressive, well-diversified all-equity portfolio during the worst of the financial crisis? How much sleep lost? How many more meaningful life experiences did you pass on while you were exhausting your resolve to stay the proverbial course?
And for what benefit? Assuming you didn’t do what studies suggest we’re prone to do–bail out at the worst possible time, thereby eliminating any benefit whatsoever to the white-knuckle ride–you may have made more money.
But can you get the best of both worlds? All-equity returns with less risk? Historically, at least, the answer is yes.
Thanks especially to the groundbreaking work of economists Eugene Fama and Kenneth French (and the number-crunching of my colleagues, Larry Swedroe and Kevin Grogan), we find evidence that an optimally diversified portfolio with only 60% exposure to stock volatility has enjoyed returns nearly equal to the 100%-stock S&P 500 index (going all the way back to 1927).
But with 40% in stabilizing short-term government bonds, this simple portfolio has required less of an expenditure in personal risk tolerance because it has endured meaningfully less volatility than the all-equity index.
So, how do you want to spend your tolerance for risk? Glued to every market update, stressed through every downturn, fighting the temptation to capitulate at the bottom?
Or pursuing the hopes, dreams and goals in life that bring the deeper meaning we seek?
This commentary originally appeared June 25 on Forbes.com
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