Basic Asset Allocation and Risk Tolerance (cont’d) – My Road To Financial Independence Series

This  post  completes the discussion of risk tolerance and is the 3rd post in a multi-post series walking through all the key financial decisions that led to financial independence in our 30’s. Make sure you read them in order as each post builds on the last. 

Don’t Fight Your Emotional Self – Find Coping Mechanisms

Based upon my tolerance for volatility in poker and my strong belief in Stocks for the Long Run, I was ready to start our investment portfolio with a 100% stock allocation and no bonds for the foreseeable future. Luckily I had the cognizance to know my tolerance wasn’t the only factor. I would also be investing my wife’s hard earned income on behalf of our family. It is of absolute importance for both spouses to have the same aligned goals, tolerance and financial values when it comes to investments. We found the following tricks helpful to alter our emotional tolerance.

Stay Out of Your Own Way

My wife was not a risk taker at all. She had little interest in the stock market and had seen the negatives of it affect their family during the dotcom boom and bust. Her primary interest was in real assets such as real estate given the bulk of her family’s wise financial decisions were due to real estate.

It took time for her to get accustomed to the volatility of my poker playing.  When I told her about a day with a large win, her instincts were to cash out. When I told her about a big loss, she would feel anger and distrust in my ability. Both reactions are perfectly reasonable and how most individuals would react. She allowed me to continue playing through all the ups and downs because she could eventually see the pattern of a slow gradual rise of the poker bankroll. She came to truly believe in my poker “edge”, but it still didn’t prevent emotional responses to the swings.

We decided that since she believed in the process, it was best to minimize how often I would talk about the swings. I began only updating her once every few months about the poker playing balance. When it came time to discuss investment selection, she did not have my same belief system in the wonders of the stock market. I explained Stocks for the Long Run to her and the rational framework I had for building our financial independence. Her belief wasn’t as strong as mine, but she had faith in me to choose something that would be the best for us long term. She intelligently knew her coping mechanism ahead of time – “Don’t tell me about the ups and downs – I’ll ask when I want an update”.

It is important to invest the time to select an overarching set of investment principles that matches your family’s temperament. After that, stay out of your own way from being emotional!

Ensure You are Only Investing Long Term Money

The emotional response to investing happens when you think about market losses in reference to what those dollars could have been used for today. A common thought when a random portfolio decline of $20,000 occurs is how it could have bought the dream vacation you have been waiting for or been used for your child’s university dues in a few years.

To invest properly, all true NEEDS like your child’s tuition have to be addressed before allocating any money towards your savings. The evaluation of a WANT should be done on a rational basis versus your current financial circumstance. If the dream vacation fulfills a lifelong goal, then it is reasonable to forgo investments to save directly for the trip. We do need to enjoy life currently while we save for the future.

Be honest with yourself ahead of time if the money you are placing in an investment account is truly for long term retirement. I personally have never withdrawn a single cent from any of our RRSP/TFSA/RESP or Corporate Investment Account. I view it as one of those firm behaviors that should have almost no exceptions. Emergencies should be covered by available quick access cash flow (line of credit or 3 months income in savings accounts) Cash needs for disability or death should be covered by insurance.

It is easier to accept market volatility when you truly view the money as units for your future self and which you have no access to currently. One of the few benefits of a financial advisor is the extra layer of scrutiny that will occur for anyone thinking of withdrawing money from savings or changing their investment process.

View Your Portfolio At The Adjusted Low Market Value

It is easy to feel rich when your portfolio is rising quickly in value during market highs. This tends to lead to increased investor confidence and spending. I choose to view my portfolio as potentially dropping by historical volatility. The empiric evidence presented in the last post shows a bear market (large losses) occurs around every 10 years. It shows the vast majority of these recovers within 2 years.

Given my allocation to 100% stocks, I currently assume a 30-40% market drop is around every corner to combat any internal irrational exuberance. If this level of volatility makes you cringe, then you need to adjust your bond allocation upward to the point of sleeping well at night.

Plan For Market Drops Instead of Fearing Them

I find that assuming an event will occur and discussing your actions helps normalize the event instead of having emotions take over. Warren Buffett speaks often about how most investors do not have the right temperament to not follow the herd mentality associated with the vagaries of the stock market. He has built a career out of having idle hands building up cash during times when the market was exuberant and buying like a kid in the candy shop when everyone feels like the world is ending and stocks will fall forever.

We will never achieve the valuation expertise or market timing of Warren Buffett. It is very difficult to know when market exuberance is about to peak. Fear and panic of herd mentality is easier to see. The difficulty is that sitting on cash for years waiting for these opportunities has proven to be sub-optimal. The gains after a market crash are missed because the investor is perfectly trying to time the bottom which is next to impossible. Analysis paralysis will often lead to a prolonged period out of the market during the recovery phase.

I suggest staying fully invested all the time to not suffer from analysis paralysis. In a greater than 15%-20% market drop where investor sentiment has turned emotional, find temporary life changes that can be made to create a higher savings rate during the downturn. This may include:

a)doing some extra professional work

b)reducing short term “wants”

c) Allocating as little to low cost debt as possible

If you can view the temporary market decline as a long term opportunity, you quickly forget about the temporary decline in your portfolio. Remember the empiric evidence shows 90% of large market declines recover within 2-3 years.

There are also some advanced investment strategies that can be helpful to utilize during a market downturn to help grow long term portfolio size. I will touch on these ideas in a few posts once we have covered more of the basic framework.

Final Thoughts

The primary purpose of the last two posts is to try and explain my rationale for choosing a 100% stock portfolio. I felt we had numerous factors that made short term volatility less concerning to our family. The most significant factors in this decision was beginning wealth accumulation at age 27 which allows for a very long runway for stock returns to prove their superiority over bonds. Having 2 stable physician incomes that was far above our required amount to live also helped tremendously.

I think the statistics from the Market Risk post should make you feel more comfortable with short term volatility in exchange for long term superior returns via a higher allocation to stocks. Reading Stocks For the Long Run and finding other resources that discuss long term historical trends for each asset type will help tremendously.

Please DO NOT take this post to be a blanket piece of advice that all readers should have 100% stock portfolios. Each individual needs to do their own risk tolerance assessment and determine their comfort zone. I simply wanted to explain my decision as it relates to our circumstances. I do believe this asset allocation strategy was one of 3 major unique decisions that allowed us to reach financial freedom much earlier than expected.

My hope for these last 2 posts is that by reviewing the empiric evidence on asset returns and objective data on stock market volatility, it will help professionals with a long time frame of investment to possibly shift their initial emotional risk profile to increase their stock weighting 5- 10% higher. A simple change like this done at a young age can translate into $1 million or more future retirement dollars ASSUMING YOU CAN STAY OUT OF YOUR OWN WAY!

Facebook Comments

5 comments On Basic Asset Allocation and Risk Tolerance (cont’d) – My Road To Financial Independence Series

  • Thanks again, looking forward to more posts!

  • You remind me of gocurrycracker’s allocation with your all-in mentality. I’ll be curious to see over time if your wife’s lower risk tolerance affects the long-term viability of your plan. Appreciate your sharing,

    CD

    • Hi CD

      Thanks for the comments!
      This post reflected my wife’s positioning on risk tolerance back when we were finishing residency.

      Our current financial position is quite far ahead of where we initially targeted for FIRE by age 45. We could take a 50% market drop and still be on pace for our initial goals.

      Over 10 years of constant financial discussion and further education, my wife is totally on board with the concept of lumpy long term superior returns. She sees and understands the benefit when taken over a 15+ year timeframe.

      The freedom of FIRE and still planning on working part time is the ability to feel less concerned with market swings. We dont need to rely on savings currently to enjoy our current lifestyle with part time work.

      Having daid that, all the research on Safe Withdrawal Rates point to high equity exposure being key to riding out volatility in a greater than 35 year retirement plan.

      I totally agree and believe that both spouses need to be completely on board with a financial plan to avoid behavioral mistakes. You should never take more equity exposure that you can’t handle behaviorally!

      Cheers
      FFMD

  • Dear FFMD
    Thanks for this and all of your other posts. I have been immersing myself in the personal finance literature for the last 5 months with the plan to go full DIY in the next year.
    I am not in quite as favorable of a position as yourself and I too have come to the conclusion that I should be 100% invested in stocks. My advisor won’t allow it currently but that will change.
    I also was an avid poker player in university and agree there are several parallels.
    Please keep posting. I’m making my way through your posts so I may be missing it but an approximate example of your portfolio allocation would be of great interest to me as I try to learn more about ideal allocation as it relates to taxation.
    Thanks

    • Hi Cowtown MD

      Great to see you taking your financial future into your own hands!
      I have been horribly slow to putting forward my asset allocation structure mainly because I wouldn’t recommend it to the majority of readers as I actively invest on my own.
      This goes contrary to the objective evidence that passive indexing is likely to outperform for investors.
      I will likely do a post at some point covering the basics of index investing, but referring to the couch potato portfolio is where I direct most people. The PWL guys have produced some excellent stuff on tax efficient investing as well.

      My strategy works well for me but likely isn’t reproducible for most!

      Cheers
      FFMD

Leave a Reply

Site Footer

%d bloggers like this:
Skip to toolbar