A common asset allocation advice is by the age of the investor. There is that rule of thumb “age in bonds” which says a 30-year-old should have 70% in stocks and 30% in bonds and so on.
That of course does not take into consideration the investor’s risk tolerance. However, risk tolerance is somewhat vague and abstract.
How do you measure risk tolerance? Some investment companies created risk tolerance scoring questionnaires. You answer some hypothetical questions and receive a score which is then mapped to a recommended asset allocation.
Still, because the questions use abstract concepts like percentages, I don’t think they do a good job in communicating the risks and measuring people’s true risk tolerance.
It occurred to me there is a good risk tolerance metric: loss-to-income ratio. The loss-to-income ratio (LTI) measures the potential loss of a portfolio relative to the investor’s income. If the investor is working, the income is the investor’s salary from his or her job. If the investor is retired, the income is the income needed for living expenses and taxes.
For example, if you have a $100,000 portfolio and it drops by 30% in a bear market while your annual income is $50,000, the LTI is
$100,000 * 30% / $50,000 = 0.6
It means that you lose from your investments 0.6 years or 7.2 months worth of your income. If you think that’s acceptable, then the portfolio’s risk level is OK.
I like the loss-to-income ratio better than a simple potential loss percentage because it connects the absolute size of the potential loss with the investor’s income and makes it really click.
For instance if the same investor has a $1 million portfolio, a 30% loss means a potential loss of 6 years worth of income. I don’t know about you but I’m OK with losing 7 months worth of my salary but losing 6 years worth of my salary is just too much, even though the portfolio loss percentage is the same.
On the other hand if this investor has a $10,000 portfolio, the same 30% loss is not even one month worth of salary, which can be replenished relatively quickly.
Now that we are close to year-end, we can do a review. First calculate how much money you have lost in your portfolio. The loss is basically
Value at end of last year + Money you put in this year – Current value
Next calculate your loss-to-income ratio. How many months of income have you lost? How many months of income are you OK with losing?