Understanding the Practical Limits of Risk
The financial industry often relies on subjective questionnaires and surveys as an attempt to define the risk tolerance of investors. The problem we have with this conventional approach is that risk and risk measurement is an exercise of real numbers. Subjective feelings or answers about risk do not present investors with an opportunity to gain the insights to make better investment decisions. We find it useful to address the issues of risk and risk management on a definitive basis. By using this approach we are able to define the practical levels of risk that investors can tolerate While investors are going to be different from each other we have further found that the practical level of risk that affects investors is not that much different in real terms.
We make the observation that too much downside volatility (risk) can take away return and too little volatility can take away the ability to achieve an effective return. We define effective return as an after tax return that is greater than inflation.
Fixed income investments historically have not been able to generate an after tax rate of return greater than inflation in taxable environments. They have lower risk but they have not proven to be return effective on a longer term historical basis.
The stock market at times presents too much downside volatility and exceeds the practical risk limits of most investors. When the stock market declines 40%, a 67% increase is required to recover the 40% decline. Portfolio recovery time is a vital component of portfolio design
Our research and analysis indicates that the practical limit of downside risk volatility for the majority of investors falls within a range of minus 10% to minus 25%. The defined use of the capital will further identify the practical level of risk each investor is capable of bearing.
| Market/Capital Decline |
Percentage Gain for Recovery of Capital |
|---|---|
| Minus 10% | Plus 11.1% |
| Minus 15% | Plus 17.7% |
| Minus 20% | Plus 25.0% |
| Minus 25% | Plus 33.3% |
| Minus 40% | Plus 67.7% |
| Minus 50% | Plus 100% |
The additional critical factor in the determination of one's practical risk limit is whether there is a required spending or withdrawal rate from the investment capital. Example: If the spending rate is 5%, a two year total withdrawal is 10% which would be in addition to any market based decline in value. If investment results had a decline of 10% plus the 10% spending the total combined asset value decline would equal 20% and require a 25% increase to fully recover the portfolio value prior to the market decline phase.
Past performance is not indicative of future results.
The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. Any opinions are those of Charles H. Ballou, CFP® and Michael C. Ballou, CFP®, and not necessarily those of RJFS or Raymond James.
The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.
