Investing is as much about understanding the markets as it is about understanding oneself. At the heart of every investment decision lies a fundamental concept: investor risk tolerance. This term encapsulates not just the capacity to endure financial loss but also the psychological readiness to face the ebbs and flows of investing.

• A person with low-risk tolerance is either unwilling to endure much portfolio volatility or may not be able to given the financial resources supporting their lifestyle needs.

• A person with high-risk tolerance is either willing to live with the discomfort of portfolio fluctuations or possesses ample financial resources to fund their lifestyle needs.

Most of us fall somewhere in the middle. We understand that our portfolios will fluctuate in value as market conditions change but we also do not have unlimited resources to not pay attention and seek to dampen those fluctuations.

Unless your name is Sam Bankman Friedman of FTX fame you are like all of us risk averse. We don’t like portfolio fluctuations and we get nervous when our financial resources experience a hit. How stressed we get and what we do about it is the story of risk tolerance.

Risk tolerance is influenced by a variety of factors including but not limited to financial goals, income, age, and life experiences.

However, it is the psychological underpinnings—the fear of loss and greed for gains—that often dictate investment choices more than we might like to admit.

The Challenge of Overcoming Comfort for Financial Goals

At the core of investor risk tolerance lies a psychological battle between the quest for safety and the pursuit of financial objectives. Individual psychology, shaped by personal beliefs and past experiences, plays a pivotal role in shaping one's approach to investment risk

Emotional Makeup and Money Beliefs:

An investor's emotional makeup and beliefs about money significantly influence their risk tolerance.

These beliefs are formed over the years, rooted in personal experiences, cultural background, and even the financial habits of one's family.

For some, these experiences instill a cautious approach to investing, emphasizing the preservation of capital over potential gains. For others, positive experiences with risk-taking may foster a more aggressive investment stance.

One of the most significant psychological hurdles for investors is the need to step outside their comfort zones.

Investors must confront and manage their fears and biases to align their portfolios with their financial objectives. It involves a conscious effort to understand and mitigate the impact of these psychological factors on investment decisions.

Financial Resources and Time Horizon:

The cornerstone of investor risk tolerance is the individual's financial resources and investment time horizon.

Financial resources, including current income, savings, and investments, dictate the ability to absorb losses without impacting one's lifestyle significantly. A solid financial foundation often allows for a higher risk tolerance, as investors can withstand short-term market fluctuations without needing to liquidate assets prematurely.

Time horizon plays a crucial role in determining risk tolerance. Investors with a longer time horizon—those investing for long-term goals such as retirement—can typically afford to take on more risk. The rationale is simple: they have more time to recover from potential market downturns. Conversely, those with short-term investment goals need to adopt a more conservative approach to minimize the risk of loss.

Experience with Past Crisis:

Beyond financial capacity and the emotional aspect of risk, another critical determinant of risk tolerance is prior experience with periods of capital market stress.

Just ask anyone who’s lived through the 2008 Financial Crisis and the March 2020 COVID-19 market meltdowns. Nobody enjoyed those collapses but most people will say that the experience taught them some valuable lessons.

• It taught them to remain sane and grounded in the face of total panic and stress.

• It taught them to be patient and wait for the storm to end before attempting to steer the ship again and possibly course correct.

• It taught them to anticipate a recovery whose timing may be wildly uncertain but whose arrival carries an air of inevitability.

The essence of how much investment risk a person should take often boils down to a single question.

This question highlights the delicate balance between an investor's willingness to accept risk and their need to do so to satisfy financial objectives.

The Balancing Act

The balancing act between willingness and ability to bear investment risk is nuanced as we’ve seen, influenced by factors such as time horizon, emotional resilience, financial resources, and lifestyle flexibility.

Investors with a longer-term perspective are better positioned to navigate the ups and downs of the market, as they can afford to wait out periods of volatility in anticipation of eventual recoveries.

This long-term view aligns with the historical tendency of markets, particularly equities, to recover following corrections, ultimately trending upward over extended periods.

• For those with substantial wealth relative to their retirement needs, a conservative investment approach may suffice. Their financial cushion allows them to prioritize capital preservation over aggressive growth, minimizing exposure to market volatility.

• Individuals whose financial assets are modest in comparison to their projected spending needs face a different reality. To achieve the necessary rate of return, they may need to accept higher levels of risk by allocating a greater portion of their portfolio to equities. This strategic tilt towards riskier assets is a calculated decision to bridge the gap between current resources and future expenses.

Tying Risk Tolerance to Target Asset Allocation

In the pursuit of financial objectives, aligning risk tolerance with asset allocation is a pivotal part of any strategy.

While pinpointing one's precise risk tolerance might not be feasible, investors can generally identify whether their tolerance is high, medium, or low. This knowledge is key for determining a suitable asset allocation mix, balancing between equities, bonds, alternatives, and cash to match their investment profile and goals.

Visualizing risk tolerance and asset allocation decisions can be simplified using a 2x2 matrix, where one axis represents the willingness to bear risk and the other the ability to bear risk. This matrix helps in conceptualizing how different levels of risk tolerance—derived from a combination of willingness and ability—translate into asset allocation strategies.

The 2x2 matrix serves not just as a theoretical model but as a practical guide for making informed asset allocation decisions. By assessing your position within this matrix, you can tailor your portfolio to align with your target risk tolerance.

Higher Risk Tolerance:

Individuals with a high tolerance for risk, both willing and able to bear significant market volatility, may opt for a more aggressive asset allocation. This strategy is typically characterized by a higher proportion of equities, which, despite their potential for substantial fluctuations, offer greater opportunities for higher returns over the long term.

The GF Higher Risk allocation weights are representative of one such strategy.

Moderate Risk Tolerance:

Those with a medium risk tolerance strike a balance between equities and fixed-income securities. Their portfolios might feature a mix of stocks for growth potential and bonds for income and stability, aiming to achieve a moderate level of return while managing risk exposure.

The GF Moderate Risk asset mix serves as an example of a portfolio with moderate expected risk and return expectations.

Lower Risk Tolerance: 

Investors with a low-risk tolerance, prioritizing capital preservation over growth, are likely to lean towards a conservative asset allocation. This approach is dominated by bonds and cash or cash equivalents, which offer lower returns but significantly reduce the likelihood of principal loss.

The GF Lower Risk allocation weights are one example of a portfolio emphasizing lower levels of expected volatility as well as more modest rates of return.

Navigating the investment landscape requires more than just financial acumen; it demands a deep understanding of one's risk tolerance.

Balancing the twin forces of fear and greed, recognizing the interplay between emotional readiness and financial capacity, and aligning investment choices with personal risk profiles are foundational elements of a prudent investment strategy.

The essence of successful investing lies not only in achieving financial success but also in aligning the investment journey with personal risk tolerance. It's about making informed, strategic decisions that resonate with one's financial objectives and psychological comfort.

Investors must ask themselves:

For many, this evaluation may lead to a realization that to meet their long-term financial objectives, stepping out of their investment comfort zone is necessary. And that is what successful investing is all about!

Asset Allocation Performance Review

High-Level Observations:

• Conservative portfolios with a heavier allocation to bonds are still recovering from the 2022 capital market collapse but the trend is up. Over the last three years, the GF Low-Risk strategy is only up 1.2% on an annualized basis (before fees and transaction costs). Going back 5 years the annualized performance improves to 4.8%.

• Equity-heavy allocations have outperformed more conservative allocations thanks largely to the performance of US large-cap equities. The GF High-Risk strategy is up 2.9% on an annualized pre-cost basis over the last three years. over the last 5 years, the strategy is up a respectable 7.5%.

• Bonds have historically provided a cushion during stock market corrections but in 2022 we saw both stocks and bonds take a big hit. The US Aggregate Bond Index was down 13% while the S&P 500 dropped 18%.

• The key lesson is that capital market corrections take a big toll on investor portfolios in the short term but given time, history suggests a very high likelihood of full recovery and continued gains.

• The heavier the allocation to riskier assets such as stocks the bigger the fall but the faster the recovery. Equities typically give the investor the ability to recover more rapidly than bonds. That’s why you see equity-heavy allocations recovering faster from the bear market of 2022.

• Bonds failed to insulate the fall of equities in 2022 due to the historically low interest rates prevailing before the correction. The conditions today are different with the 10-year US Treasury yielding over 4%. The good news is that the diversification potential of bonds has dramatically improved given the higher yields.

Weekly Performance Attribution

Source: iShares, as of 2/6/2024

A Bit of Humor Never Hurts

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