The Risk of Taking on Too Much Risk

After the third year in a row of double-digit stock gains, statements like “Just buy VTI and chill,” are getting louder. Jason Zweig wrote in The Wall Street Journal, “Should You Just Buy Stocks Until You Die?” And in a predictably irrational way, clients are wanting very little fixed income, saying that stocks always bounce back quickly.

Yet only a few years ago, when Covid-19 hit, there were sounds of “this has never happened before” as people fled stocks and the shortest bear market in history ensued. The logic they gave was compelling. (And I admit that selling some of the safety of bond funds at the time to buy more stock index funds, in order to rebalance to my target allocation of stocks and bonds, was painful to say the least.) Of course, all of that logic was priced into the bear market, and stocks ended up gaining 21% for the entire year, as measured by the total return of the aforementioned Vanguard Total Stock Market Index ETF (VTI). 

It’s a mystery to this day as to why the market gained so much in 2020 given all of the dismal economic news, so we’re not going to predict the future. The point is that the way we feel about risk is very unstable. That’s due to behavioral biases such as recency bias, where we think the recent past will continue. But good times don’t last forever, and neither do the bad ones.

The Dangers of the Risk-Profile Questionnaire

Admittedly, I ask my clients a few questions that one might see in a risk-profile questionnaire. It’s not about trying to quantify the results, but about trying to give them a reality check and all the pain that comes with it. For example, when asked what they would do if their stocks lost 50%, they typically respond that they would buy more stocks. While that would be the right answer, they should also try to imagine that half of their financial freedom, the ability to do what they want for the rest of their lives, has vanished. Though it’s hard to simulate the actual pain they would experience, embracing those feelings might change the answer.

I’ve personally taken over a dozen risk-profile questionnaires and my lowest recommended stock allocation was 70%. (My highest was actually 130%, which had me taking out a margin account.) My actual allocation is 55 % equities. So why did other scores come out so high? When I was asked what I did during the last bear market, I truthfully answered that I bought more stocks. But had I been aggressively invested, I never would have had the courage to do that. It turns out buying low and selling high is better than the reverse. Risk profile questions are beyond worthless: they are dangerous. 

The Critical Missing Factor

Not once have I ever seen a risk-profile questionnaire measure one’s need to take risk. That’s personally why I’m far more conservatively invested. I tell clients that dying the richest person in the graveyard is a lousy goal. Sure, passing the money to one’s heirs is an important secondary goal, but it shouldn’t be the primary goal. In the words of financial theorist and author William Bernstein: “When you’ve won the game, stop playing.” 

This doesn’t mean getting out of stocks completely but the consequences of running out of money are high. A portfolio void of stocks is open to possible high inflation. In fact, research shows a portfolio very heavy in stocks is exposed to a prolonged bear market while a portfolio of mostly bonds is exposed to passible high inflation. Thus a more moderate portfolio of stocks and bonds has a higher safe spend rate.

Helping Clients Set Asset Allocation Targets

Assessing both the client’s willingness and need to take risks is important. The latter is fairly easy as one can quantitatively estimate how close they are to having enough. It’s estimating one’s willingness to take risk that’s the hard part. If the client adamantly says they would buy more equities, should they plunge 50%, encourage them to consider the pain they would be feeling. If they say they hope they would be able to buy more stocks, but they know it would be painful, that’s a good sign. 

Also take a look at their tax returns to see if they have a tax loss carry forward. There may be good reasons for that loss, but often it’s because they sold in a down market. We like to forget our mistakes. In setting the allocation, advisors can use the following framework:

• If the need to take risk is low, it’s likely that recommending a conservative allocation is appropriate. (I also recommend a conservative allocation even if they have a high need, but low willingness to take risk. That’s because I think they will panic and sell during bear markets.)
• Only if the client has both a high need and willingness to take risk, should advisors recommend an aggressive allocation in most situations. 

Timing Isn’t Everything. Many times, the client wants to take on more risk than it might feel is appropriate. For example, they may want a 70% equity allocation when 60% feels more appropriate. Here, advisors can use their own money to negotiate. Tell them: let’s start with 60%, and you can go up to 70% when stocks decline by 20% or more. (Is that market timing? I insist that it’s not, but rather is testing the client’s resolve. How many clients do I remember taking me up on increasing risk in a bear market? Zero!)

Setting one’s asset allocation is at least as much art as science. In good times like now, we overestimate our willingness to take on risk. In bad times, we often flee to cash. Whatever allocation the client selects, tell them that being consistent is more important than getting it right in the first place.