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?
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our loss has been 1/3 of our household income for the year (married couple)
so that means that we lost 4 months of our combined salary (or 14 months of my wife’s salary).
that is with an 80/20 stock/bond portfolio
yeah, it hurts, but as much as I like your loss/income, it seems that it would lead to essentially no risk taking with a larger portfolio
for instance, if my portfolio becomes 10x larger (here’s hoping!) then a 10% loss would equal one year of our combined income…
yes, the need to take risk drops as wealth increases (in general), but does it drop that much?
Harry Sit says
While I think the loss-to-income ratio puts the risk tolerance in better context than a simple percentage, I’m not suggesting where the line should be drawn. That has to be a personal decision. I think your loss of 4 months of salaries would be within my boundary of acceptable loss (when you talk about a combined portfolio, you have to use combined salaries). Even the prospect of losing one year of income might still be OK for me. But if it’s going to be five years, I will definitely not take that kind of risk. I think this kind of self-discovery is helpful for constructing an asset allocation that’s within one’s risk tolerance.
That’s a useful measure, but it is not without its difficulties. It is skewed by really small or really large portfolios or really large or really small incomes. It also doesn’t measure the opportunity cost of investing in a low risk portfolio. Losing six years worth of salary is bad, but if you have to give up ten years worth of gain to avoid that loss, you are worse off. Still, it is a lot more effective than simply listing a percentage, and it should work reasonably well for people within ten years of retirement.
Bert Whitehead says
This is very interesting. However, It doesn’t take into account how much risk is being taken in other areas, (e.g. real estate, own business, etc.)
Nor does it take into account how many others are affected by your losses (e.g. are you single, or married with 4 kids to provide college for, and supporting aging parents?).
Most importantly, it doesnt’ take into account how much risk you need to take to get where you want to go.
Nor does it take into account net present value of the investment…if the market drop is a short term glitch, while one’s investment horizon is long term such as for retirement accounts, the ration is of very limited usefulness. it does quantify risk a bit better but ignores long term trends.
Harry Sit says
m.east – You never know whether a market drop is a short term glitch or not (think Japan). Even though one’s investment horizon is long term, not everyone should be 100% in stocks or 150% in stocks with leverage. You have to consider your risk tolerance. As Mike Tyson said, everyone has a plan until they get punched in the mouth. You want that punch to be within your tolerance, not one that knocks you out and makes you abandon your plan.
I think a better way to look at this is from retirement looking backwards from the perspective of how much your account can generate in income and how much is lost really.
For a $1 million portfolio, this can generate safely around 4% or $40,000 a year. If it drops by 30% you can generate 30% less or $28,000. This would be a drop in your retirement salary by $1000 a month. Certainly much easier to see than a loss of six years of income, which really it isn’t.
$12,000 of lost income per year, would need to continue for 25 years for you to really lose $300,000.