Risky Business - Tolerance vs. Capacity
Think back to the last time you gambled – be it Vegas, a bingo hall or gas station lotto. Did you gravitate to the ‘high rollers’ room or the penny slots? What were your expectations: entertainment or game changer? Did you have a pre-determined budget: $100? $1000? $10k? Like most recreation gamblers, you probably have a reasonable balance between your capacity for risk and your tolerance for risk. Ironically, this symmetry disconnects in real world investing.
Think of capacity as your financial horse power and the tolerance as the steering wheel. Ideally, there is alignment. Your financial goals match your investment profile. They are realistic and attainable. Your capacity encompasses your income, savings, age, cash flow, debt, health – basically your financial finger print. Fairly simple. The more difficult task is properly assessing risk tolerance. Similar to pornography; it’s hard to quantify but you know it when you see it. How do you react to financial volatility? Do you focus on returns or risk? Do turbulent markets shake or excite you? Everyone’s greed & fear index is unique. We compartmentalize gains & losses differently. The market winds easily sway most investors’ goal posts. Kittens become roaring lions in bull markets and scurrying mice when the bear growls.
Money is complicated. It’s emotional. Some fixate on returns while others are risk mongers. Studies have shown that the pain of financial loss is twice the pleasure of a gain.[i] This loss aversion can sometimes be a helpful tap on the shoulder. It can reset an investment profile gone astray. When I was a young piker at Paine Webber, my first manager dropped this pearl: “The stock market can be an expensive place to find out who you are”. Unfortunately, most investors never look in the mirror.
We’ve witnessed the very affluent (high capacity) invest strictly in municipal bonds (low tolerance). Modest, fixed income grandma buying just CD’s. And young, high earning professionals all in stocks. Makes sense. The real detachment happens when conservative savers start loading up on, say, Bitcoin? Contrary to the children’s fable: they are still sheep in wolves’ clothing. The $5 black jack player has wondered over to the $100 craps table. Maybe the graphic below helps visualize the concept.
This matrix basically depicts your ‘wants’ on the risk willingness axis vs. the ‘can’ on the bottom capacity axis. There is not necessarily an absolute right or wrong answer – just a different way to weigh risk. Inappropriately, most investors reach for higher returns at the expense of capacity. Maybe it’s time to take an honest inventory & rebalance accordingly.
The market is now entering the Ice Cream stage – everyone wants some. Hey I get it: when the getting is good, more is always considered better. But, statistically, we are likely in the latter innings of this bull market – at 8 ½ years, it is one of the longest in recorded history. Sure, it can, and probably will continue; but not indefinitely & certainly not knowable. Most of us realize that but prosperity breeds over-confidence. We all think we’ll be safely home in bed when the party gets busted. Plan your exit accordingly.
Fiscal Fitness is a publication of Houlihan Asset Management, LLC for the benefit of its clients and friends. Houlihan Asset Management. Wealth Counseling/Asset Management. Copyright 2017
[i] Rolf Dobelli, The Art of Thinking Clearly, (Harper Collins 2013), p. 96.