Risky Business

When you visit a finance adviser, the first question is usually to determine your risk tolerance. It is a critical input into your asset allocation. However, after 25 years of investing, I have yet to see an "older" person have a high risk tolerance and a young person be deemed risk averse. The standard line is the longer you have to invest (being young) the more risk tolerant you should be. The older the more risk averse you should be. 

This is completely wrong. For starters, our risk tolerance or aversity is not a permanent state. It changes. Notice normally risk averse people suddenly decide to borrow a lot of money to invest in a property for example. Or when the market falls a lot, people become risk averse when they should be tolerant thanks to higher long term yields. 

Imagine after a 50% decline in the stock market, your financial adviser says, based on history and your current situation, you should invest a lot because the market is cheap and yields are high, many people will follow that advice even though they may be deemed to have be risk averse.

Risk is not really about how you feel. Your risk tolerance is a personal characteristic. In most cases, it's because we are not aware of market history or market dynamics. Most folks who don't study investing don't realise how markets cycle from low risk to high risk and back again. So they don't have all the information necessary to make a rational decision. If they did, then their risk tolerance would change depending on the current market situation. This is the optimal approach whether you are 15 or 50. If a cheap market offers solid 10 year returns, then you should raise your allocation regardless of your "risk" tolerance or your age. There is simply no connect between you feel and the actual expected return. 

This is why it is important to learn about investing. One or two market cycles is sufficient for most people to grasp the market dynamics and understand that their own feeling won't be correlated with their returns. Indeed, we also know that our brains are prediction machines and when things go bad, we think it will continue to go bad. Again, history shows that the opposite actions are the most beneficial. When markets crash, dive in. When they are crazy expensive, get out or at the least minimise your allocation. 

Don't fall for the argument that you have to be invested 100% of the time. That is not how great investors like Warren Buffett got fabulously rich. Buying cheap and selling expensive is the way to go regardless of your risk tolerance.