How Much Risk Should You Take?

TL;DR

The right amount of investment risk is enough to help meet your goals without exposing them to catastrophic failure, based on your ability, willingness, and need to take risk. Longer horizons generally support more equity risk, while shorter horizons favor more bonds. Globally diversified index funds can remove company-specific risk, but not market risk. Read on to see how time horizon, human capital, potential losses, and retirement needs shape the decision.

Transcript

Risk is more than an important part  of investing. The whole concept of   a financial market exists on the basis that  taking risk can result in financial gain. If   you do not take risk in financial markets,  you expect very low returns. Of course,   with risk also comes the potential for  loss. Elroy Dimson of the London School   of Economics sai... Read More

Key Insights

• ✳️ Risk in investing is essential because it creates opportunities for financial gain.
• ✳️ Idiosyncratic risk is specific to individual stocks and can be diversified away, while market risk cannot.
• ✳️ Globally diversified portfolios of index funds help to eliminate idiosyncratic risk and capture market risk.
• ↩️ The allocation to bonds in a portfolio affects its risk and returns, with stocks historically outperforming bonds.

Questions & Answers

Q: How much investment risk should you take?

Take enough market risk to help meet your financial goals without creating the potential for catastrophic failure from a large decline at the wrong time. The appropriate amount depends on your ability, willingness, and need to take risk, so there is no single optimal allocation for everyone.

Q: What determines your ability to take investment risk?

Your ability to take risk is primarily determined by your time horizon and human capital, including your remaining earning capacity. It is generally sensible to take less risk for short-term goals and more risk for goals with longer time horizons.

Q: How does willingness to take risk affect a portfolio?

Willingness reflects how much volatility and potential loss an investor can tolerate. The MSCI All Country World Index fell 33% in Canadian dollars between March 2008 and February 2009, and anyone considering a 100% equity portfolio should be comfortable with the possibility of an even deeper decline.

Q: What does it mean to need investment risk?

The need to take risk depends on whether low-risk assets alone can fund an investor’s goals. Someone seeking $5,000 per month, adjusted for 2% average inflation over a 30-year retirement, would need about $2.5 million to afford taking no risk; investors with less may need risk to increase expected returns.

Q: What is the difference between idiosyncratic risk and market risk?

Idiosyncratic risk is company-specific risk that is not directly related to the overall market and can be diversified away. Market risk affects the market as a whole, cannot be diversified away, and is associated with an expected positive long-term return.

Q: Why use a globally diversified portfolio of index funds?

A globally diversified portfolio of index funds helps eliminate the specific risks associated with individual companies. This leaves investors exposed mainly to market risk instead of letting the outcome be dominated by one stock or sector.

Q: How does adding bonds change a portfolio’s risk and expected return?

A portfolio becomes less risky and has a lower expected return as its bond allocation increases. Over the past 116 years covered in the transcript, stocks outperformed bonds globally, while bonds were less volatile.

Q: Does a longer investment horizon make equity risk more manageable?

Equity market risk has tended to pay off over long periods, while the distribution of outcomes tends to narrow. Across 877 overlapping 15-year periods from 1928 to 2015, the US market outperformed risk-free Treasury bills 96% of the time, though long-term outcomes remain uncertain.

Summary & Key Takeaways

• Risk is inherent in financial markets, and without taking risks, investors can only expect low returns.

• There are two types of risk: idiosyncratic risk, which is specific to individual stocks, and market risk, which is the risk of the market as a whole.

• Idiosyncratic risk can be diversified away, while market risk cannot. Investors aim for long-term positive returns by taking on market risk.