I believe that most people have a very similar tolerance for investment risk. Most people are comfortable achieving a long-term annual return of 7% to 10% if the risk of losing money is very low. In short, I think most people have a low appetite for risk – they prefer to take as little risk as possible and invest in a “sure thing” if the return will be enough for them to meet their goals.
What is a risk profile
Risk is the probability of not achieving your targeted investment returns. This might happen in two ways.
Firstly, the investment might end up being a dud with little prospects of ever delivering the returns you desire i.e., an investment mistake.
Secondly, you might not achieve your returns temporarily, due to intermittent volatility. For example, if you invested in the Australian share market in May 2021, your return just over one year later is zero, as over that time, the market risen, fallen, and subsequently recovered back to May 2021 levels (ignoring dividend income). But this volatility is almost certainly temporary. We know that over multiyear periods (e.g., a decade or longer), the market has always trended higher.
Most people are only concerned by the first risk because they know volatility is normal and are happy to endure it if they will be rewarded adequately in the long run.
That said, some people, albeit a minority, have a low tolerance for intermittent volatility.
How do you measure your risk profile
The traditional way to measure risk tolerance is by asking a series of hypothetical questions to measure your comfort/discomfort with experiencing volatility and investment losses. This questionnaire is a good example, which we use in our practice (it’s based on this paper).
However, I am skeptical that these questionnaires provide reliable information. It’s one thing to predict how you’d feel if your investments fell by 30% of value, but until you experience it, you don’t know for sure. We know that humans have a strong cognitive bias for loss aversion – the pain of losing is psychologically twice as powerful as the pleasure of gaining.
95% of people have the same profile
I describe most people’s risk tolerance below (including my own):
I work hard for my money, so I don’t want to take high risks and risk losing it. I’d be happy to generate a long-term investment return of 7-10% p.a. as I know that if I do that, it will help me build substantial wealth over many decades. But I want to take as little risk as possible to achieve that.
Warren Buffett famously has two rules for investing. In essence, he counsels investors to not take huge risks. Don’t gamble with your money. Only invest if you are convinced that there’s plenty of upside and very little (no) downside risks.
5% of people have very different risk appetites
There are always outliers. Some people will have a very low tolerance for risk and therefore should skew their investments towards safer, low-volatility asset classes.
Conversely, some investors have a very high-risk tolerance and enjoy “betting the farm” in the pursuit of high returns.
But both cohorts constitute a very small minority, arguably even less than 5% of all investors.
At some point, capital preservation becomes more important than capital returns
Investors know that they must be prepared to take some risk to generate investment returns. Being too risk adverse is risky in and of itself because if you don’t invest appropriately and sufficiently, you may not achieve your financial and lifestyle goals e.g., not enjoying a conformable retirement.
However, once you have sufficient investment assets to achieve your goals, capital preservation may become more important than investment returns. That’s because you no longer need investment returns to achieve your goals. As long as you don’t lose money, you’ll have a comfortable retirement. In that situation, it is very important that investors adopt a well-thought-out asset allocation, which is likely to be lower risk.
You don’t need double-digit returns to achieve your goals
Most growth asset classes, and investment markets have returned more than 10% p.a. over the past 3 to 4 decades, including Australian residential property and the Australian, US and international share markets. If you earn a 10% p.a. return, your investments (value) will double every 7.3 years. That is more than enough for most people to achieve their goals. Therefore, targeting a long-term return of say 8% to 10% p.a. is enough.
How do you achieve these returns whilst taking the lowest risk possible?
Here are a few suggestions:
- Only adopt rules-based and evidence-based investment methodologies. You reduce your risk by adopting proven methodologies, not throwing darts at a dartboard. A rules-based approach means that if you follow a set of rules, you should enjoy predictable returns over the long run. And if there’s an overwhelming amount of evidence that demonstrates this rules-based approach works, then you’ve greatly reduced your risk.
- When paying investment fees, make sure you are likely to receive good value for money. For example, some fund managers charge 1% p.a. in fees, whereas index funds charge fees as low as 0.03% p.a. It doesn’t make sense to pay significantly higher fees unless better performance is almost certain. That is not to say that you should only invest in the cheapest funds. There is evidence that sometimes it’s worth paying higher fees to access different methodologies. But overall, keep percentage investment fees low.
- Spread your eggs across many baskets. I believe that most people would be well served by investing in various asset class including direct property, share markets, bonds, and superannuation. Every asset class has its pros and cons, so at a portfolio level, these should balance each-other out. Also, as this chart shows, in the short run, returns are unpredictable i.e., there are no patterns. Therefore, if you are investing regularly, it makes sense to spread your money across different asset classes.
- Invest in markets and asset classes that exhibit the best probability of providing the highest medium-term returns. Put differently, let long-horizon mean reversion do all the heavy lifting.
- Pay for professional advice. Of course, I have a vested interest in saying that. However, it is very clear that investment mistakes can cost a lot more than advice costs. If you can benefit from other people’s experience and minimise the risk of making a mistake, that is always a wise thing to do. More importantly, mistakes cost time. And you can never make up for lost time.
It’s not worth taking high investment risk
It is my thesis that investors can generate excellent investment returns whilst at the same time adopting a low-risk approach. That is not to say that you won’t experience intermittent volatility – of course you will – every investor does. But to achieve acceptable returns over the long run, you don’t need take a lot of risk, which is an approach that resonates with a lot of investors.
