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October 11, 2019

How Risk Tolerance Impacts Portfolio Construction

How Important Is Risk Tolerance?  Your appetite for risk is only one variable in the portfolio design equation.

There is a school of thought that the makeup of your portfolio ought to be a reflection of how willing you are to accept stock market risk. The idea is that your asset allocation should be matched directly to your risk tolerance. This notion places all investors on a continuum; with conservative investors on one end of the spectrum, and aggressive investors on the opposite end. While this method of portfolio construction might satisfy your appetite (or distaste) for risk, it might also prevent you from achieving the long-term rate of return necessary to achieve your real consumption goals.

Asset Allocation: The Art of Balancing Risk and Return

Asset allocation is the process of dividing your portfolio between different types of investments. The goal is to get the mix just right so that your investments achieve an acceptable rate of return without introducing more short-term volatility (risk) than you’d be comfortable with. Investment advisors have traditionally used three common asset classes to formulate the mix: stocks, bonds, and cash.

Research (and common sense) tells us that of these three investment classes, stocks are the riskiest. You don’t need to be Warren Buffet to know that the stock market can swing pretty wildly sometimes. But, by the same token, stocks can provide investors with really high long-term rates of return.

Bonds provide investors with lower total returns (the combination of income and appreciation) than stocks. But they are also a lot less volatile. That’s not to say that bonds don’t have their own unique set of risks. They can decline in value when interest rates rise. And if the income stream they provide is lower than the rate of inflation, they subject investors to purchasing power risk – the chance that their value at maturity won’t be able to buy as much stuff in the future as it does today.

Cash doesn’t fluctuate in value the way stocks, or even bonds, can. That makes is a pretty riskless asset class. But, as anyone with a savings account knows, cash offers long-term investors a terrible investment return. And that’s the main risk of holding too much of it. Cash has lots of purchasing power risk. 

How Risk Tolerance Impacts Portfolio Construction

As a rule of thumb, the higher the potential return an investment has, the riskier it will be. The magic of asset allocation is that the right mix of these three asset classes (stocks, bonds, and cash) can provide an investor with the perfect balance of risk and return.

For example, an aggressive investor might own only stocks. A moderately aggressive investor might own stocks and bonds but have a much heavier concentration of stocks in the mix. A moderate investor looking for income and growth might have an even split between stocks and bonds. He or she might even have some cash tucked away in the mix. The vast majority of a moderately conservative investor’s portfolio might be in bonds, with just a token amount dedicated to stocks. And a conservative investor might not own any stocks at all. This person might also have a slightly larger proportion of cash than any of the other investor types.

The problem with the risk tolerance approach to portfolio construction is that it puts too much weight on an investor’s fear. Concern about short-term volatility is an important aspect of constructing a durable portfolio, but it isn’t the only consideration. For many investors, other criteria are much more important.

What to Consider When Building Your Portfolio

Certainly, risk tolerance needs to be one of the factors you consider as you construct your long-term investment portfolio. But fear of short-term volatility shouldn’t be the main driver. The reason for this is that volatility is a normal part of how the stock market behaves. Over time it has less and less impact on portfolio balances because, as history has shown, the long-term trend of the market continues to be positive.

For this reason, your age and your investment horizon (the time that you expect to actually use the money you have invested) should carry more weight than your risk tolerance. Stocks are a long-term investment. They should be used to finance long-term goals. The more time you have until you need the money, the greater your allocation to stocks should be.

Another very important consideration of the asset allocation decision is your investment objective. Just what is this money intended for? All money ultimately gets spent. So, you should think about your investment portfolio in terms of how and when you’re going to spend it. Goals that are far off into the future or that have a low priority can be financed with stocks. Imminent, high priority goals should not be. 

This isn’t to suggest that your risk tolerance or other personal preferences should not weigh heavily on your asset allocation decision. They should. But the balancing act between risk and reward needs to be performed in the context of your overall investment objectives and consumption-based goals. Opting for less risk means accepting a lower expected return. This exposes you to an even greater risk – outliving your money.

Putting it All Together

After you make your asset allocation decision think about how to construct your portfolio. Asset allocation is actually more complicated than investing in just stocks, bonds, and cash. There are many different types of stocks and bonds that can help you achieve hybrid results.

High-yielding dividend stocks can offer you both the potential for capital gains and income. Preferred stocks can offer similar hybrid results. When selecting bonds, you have equally as many choices, from government to corporate, domestic to international, inflation-adjusted to a floating rate.

Beyond traditional stocks and bonds, there are lots of alternative investments to consider. Growth opportunities with very attractive yields can be found in both listed and private Real Estate Investment Trusts (REITs). Global REITs can offer additional diversification.

 Because of the overwhelming array of options at your disposal, it is possible to effectively construct a portfolio that has a high probability of achieving the expected rate of return required to accomplish your goals. The right mix can do this without subjecting you to uncomfortable risk. A critical component of getting this balance right is to make sure that you seek the guidance of a professional advisor.


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