July 1, 2010
Many Silicon Valley investors fled the market in 2008 and the first part of 2009 and have not returned due to fear and a lack of trust in the financial markets. They are left, however, with essentially zero returns on cash investments and wondering what to do now. A good place to start is with a complete reassessment of risk tolerance.
Financial services companies have been trying for years to come up with an ideal set of questions that quickly and accurately classifies an investor’s risk tolerance and determines a precise portfolio allocation that matches it. But the truth is, risk tolerance can only be determined with experience, and experience requires time. People are naturally more tolerant of risk during bull markets and less tolerant in bear markets. Ultimately, only trial by fire will determine someone's true tolerance for risk.
An individual’s risk tolerance consists of two components—ability and willingness—and it can be helpful to look at each separately when reassessing overall risk tolerance. Ability is objective while willingness is much more subjective, and the reassessment process often comes down to reconciling the two because they often conflict. Part one of this piece deals with ability.
Determinants of ability
For individuals, ability to tolerate risk is determined by portfolio size or the overall level of wealth, the portfolio’s liquidity requirements, and the time horizon of the portfolio objective. So the ability to tolerate risk is really the ability or capacity of the capital itself to tolerate risk.
Ability to tolerate risk is directly related to the level of wealth and the time horizon and indirectly related to liquidity needs. The larger the wealth and the longer the time horizon, ability to tolerate risk increases. The larger the current liquidity needs required from the portfolio, ability to tolerate risk decreases.
If income requirements are large relative to portfolio size and the time horizon is short, ability to recover from periods of poor portfolio performance will be diminished. Thus risk tolerance is significantly reduced.
For individuals, retirement is typically a critical investment objective because it involves future standard of living. It is a two-stage time horizon for pre-retirees—pre-retirement and retirement. Retirees have a single-stage time horizon.
Even for retirees, the investment time horizon can be long term with a significant need for portfolio growth to combat the effects of inflation. People are living longer, and someone who retires at 65 could reasonably live another 30 years. The number of people living to age 100 and beyond is increasing dramatically. Investment time horizon can even extend beyond an individual’s life span if they have bequest objectives.
Ultimately, most people have a segment of their financial capital that has an increased ability to tolerate risk. The capital, then, requires the willingness by the owner to match. We address the complications of willingness in part two.
