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What if I’ve over estimated my tolerance for risk?

Ever over-fill your plate at the buffet? If you’re feeling like your eyes were bigger than your stomach when it comes to portfolio risk, there are some things you can do to lower the amount of risk you’re taking.

Transcript

Tim Maurer:
Tim Maurer, back with another episode of Ask Buckingham. A new video podcast designed to bring clarity in the midst of confusion by connecting your great personal finance questions with straightforward answers from industry thought leaders.

Tim Maurer:
Today we’ll be talking to Larry Swedroe, Buckingham’s Chief Research Officer. And Larry, as an investor I may have taken a risk tolerance questionnaire a few years ago where I checked the box, yes.

Tim Maurer:
The market goes down by 30% and I will not leave my strategy, but today in the moment, having actually felt the market’s decline, I feel a sense that I do not have the wherewithal to stick with it. What do you recommend at this point in time, if I realize I have been overconfident in my estimation of taking on risk?

Larry Swedroe:
Yeah. The first thing I would say is we are human beings, we are subject to being overconfident about all kinds of things. And smart people act in a way that differentiates them from fools in the sense that when they learn they made a mistake, and smart people make them, they don’t repeat the same behavior, as at least it’s attributed to Einstein. He said, “Doing so is the definition of insanity.”

Larry Swedroe:
So if you had overestimated your ability to deal with a 30% drop in the market, which might’ve led you to choose, say, an equity allocation of 60% and you find out you can’t, and maybe you should have been 50% or 40%. Luckily, if that decision was made a number years ago, you’ve actually benefited because you had a higher equity allocation than you should have and you got much better returns.

Tim Maurer:
Sure.

Larry Swedroe:
However, now you’ve learned that lesson, you may have given back all or even more than those gains. The problem is you don’t want to make the mistake of the poker player who says, “All right, I’ll just stick with this until I get even.” Because there is no guarantee this won’t get worse and it will crash and you’ll be under even more stress, and then you may panic and sell. And then once you do sell, in my opinion, you’ve committed portfolio suicide.

Larry Swedroe:
Very difficult to get back in because the problem is there’s no green light. And as we saw, let’s say you got out on Monday, which is, I know one investor who did so unfortunately. And then on Thursday night he says, “What do I do? I’m up 20%.” So he gets back in, let’s say, and now he looks at the market’s down 1000 points. Now he might panic and never be able to get back in. You have to have a plan that allows you to stay in the course.

Tim Maurer:
Okay.

Larry Swedroe:
So my advice is this, we know that it is much harder to live through a bear market than observe it in the data. The pain of losses is great. It causes our stomachs to scream. So if you’ve recognized you’ve made that mistake, in one sense, the market is already corrected for that. If you were 60% stocks and maybe you haven’t rebalanced, maybe you’re 50 now, right? So maybe that’s a good time to sit and say, “All right, it was a painful lesson. I learned it. Let’s lower my investment policy statement allocation to 50% and now I won’t rebalance until it goes down to 45%.” Rather than panic selling, rather than leaving it at 60 and hoping the market will recover, which it may not. Admit the error, which is what smart people do. Learn from it and then permanently change your allocation. And the right way to do that is to sit with your advisor, run the Monte Carlo simulation and choose today what is the right number for equities based upon your own unique ability, willingness and need to take risks.

Tim Maurer:
And Larry, you talk about the ability, the willingness and the need to take risks [inaudible 00:04:29] lens through which or really three lenses through which we can view our own risk tolerance ability being, your time horizon, the amount of time you have between now and when you expect to need the money. The need being how much you need or don’t need to make in the market in order to achieve your goals. But let’s talk for a moment about this willingness. It’s been my firm conviction that that willingness, that gut check test is the most important and the most potent of all three of these lenses. Would you agree with that?

Larry Swedroe:
Yeah, I think it is certainly, very important. I don’t know that any one of the three is any more important than the others. Because for example, you may have a very strong willingness to take risks and not panic and sell and the market is dropping 50%. But if you didn’t need to take that risk, now you have to ask why was I taking it when I, you know, if the market had doubled, it wouldn’t change really anything important in my life.

Tim Maurer:
Sure.

Larry Swedroe:
So I think that you have a three legged stool, all three of those legs on ability, willingness and need have to be firmly planted on the graph. And I do want to add one other thing. Many of us tend to think about ability in terms of that horizon and the longer the horizon the more ability we have to wait out a bear market. That’s true.

Larry Swedroe:
But we also need to ask ourselves this very important question Tim, which is are we a stock or a bond? So if you have, say a doctor or a tenured professor at Washington University, their income is almost annuity light. It’s not going to be impacted too much by what’s going on with the economy. So because their income is bond like, they can take more equity risks. On the other hand, you may have someone engaged in manufacturing automobiles or running a restaurant, and those are where you’re much more cyclically tied to the economy. So you look like a stock, all else equal. If you have the same need and willingness to take risks, one of them should have a higher equity allocation than the other. So we need to take that into our cap. But the question about this willingness, it’s so important, first of all, because life’s too short not to enjoy it.

Larry Swedroe:
And if you’re not sleeping well, even if you don’t panic and sell, then I would tell you, you have too high inequity allocation and get that equity allocation down to a level that you can sleep well and not worry about having a secure financial future. The second thing is, we touched on is that living through bear markets is a lot harder than it is to observe them and our stomachs are going to get [inaudible 00:07:25].

Larry Swedroe:
We are really not logical investors in most cases. We can’t just purely look at the data, see what history shows in every single case we got out of this. We are much more psychological investors where psychology and our fear of losses, which is great. We feel the pain of a loss twice as much as we get a benefit of the joy of an equal size gain and the bigger the losses that more that ratio increases. So you really have to focus on getting it right because number one, you won’t be able to sleep well. And number two, if things get really bad, you may hit that panic button and commit portfolio suicide and get out and that green flag will never be there to tell you it’s safe to get back in the water.

Tim Maurer:
Well, thank you Larry, and if you have not yet seen the episodes that we recorded with Dr. Meir Statman , I would highly recommend you do that. Where we specifically discuss this notion of the pain of losses being twice as much painful to us as the joy of gains. Thank you also for tuning into this episode of Ask Buckingham. If you have a question that you’d like to see us address, you can do so by navigating to the website, askbuckingham.com or by emailing your question to question@askbuckingham.com or just click in the upper corner of your screen and it’ll take you directly to the website.

Tim Maurer:
Remember, there are no dumb questions. But unfortunately, there are plenty of poor answers out there. Our hope is that in giving you straight answers to your questions, it will bring a sense of calm and allow you to make what you’ve learned in pursuit of good decision making. So please follow us and by all means, Ask Buckingham.

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