Just because you want to doesn’t mean you can.
The question the coin left open
In the last post defined and defined several economic concepts. There’s wealth and it’s utility. We chase it because it buys things. Then we presented risk and people’s aversion (or appetite for) to it. We put all of it in one picture. A sure $100,000 versus a fair coin that pays $80,000 or $120,000. Same expected dollars. Different usefulness. The sure check sits on the curve. While the coin flip does not. If you need a refresher that post is here. The markdown was about $2,020 and it has a name. We call it the risk premium.
That post answered a preference. Given the same expected dollars, most households take the sure thing. That preference is risk aversion.
Now that we know about risk aversion, there’s a second question we need to ask.
Yes, you understand the markdown — sure you can collect the premium — but can your household underwrite the real risk? The hundred-year price sample paid about 8.43% on average. The miss around that average was about 18.58%. On a $1,000,000 book, a one-sigma year is on the order of $186,000 either way. Again, this isn’t a forecast, it’s an expectation. Think of it as a scale that can go in either direction. And since it can go in either direction, you focus on the downside risk.
Why? Because of what we said about utility. We did all that math here; the mood you feel can be explained by the bend in the curve and it has a formula.
The following sections will go through a couple of concepts. A quiz will tell you whether you want to ride. A balance sheet will tell you whether you can survive it. Those are not the same.
Two questions
Appetite is willingness. Will you sit through it? When the book is down and the neighbor is selling, do you still own the thing you said you would own? Appetite lives in the stomach. It shows up as a preference. We have tools that can measure it with a clean set of tickets.
That will come later.
Capacity is ability. Can your plan sit through it? Just like everything in economics, capital is scarce. It’s the first lesson. The cash you have is most likely spoken for. What about the job that funds the plan? The house that is shelter and not a trading account? The date you need to draw? Capacity lives in the constraints. It shows up as a ceiling.
Willingness is not ability. They are not the same. You need to have both if you want to speculate.
They disagree more often than a slide deck admits
You can want a wild ride and still have a mortgage, sixteen years to the first draw, and a cash reserve you are not allowed to raid. High appetite but tight capacity is not a good combination. The quiz makes you look like a risk taker. The plan tells you you’re an idiot if you are.
Or you can have a lot of dry powder and yet no stomach for risk despite what you told yourself. The reserve is intact. The job is steady. The date is in the distant future. And the first ugly year sends you running to cash because you can’t watch the number fall. You’re not a risk taker after all. High capacity. No appetite. The spreadsheet says you’re fine. But you run for the hills at the first sign of trouble.
Sell-side language treats those two failures as the same word — “risk tolerance.” They are not the same thing. They need to be treated differently. One is a sale you make to yourself because you thought you were a risk taker. Turns out you were not. The other is a hole the plan cannot refill because you took too much risk without the cash to make you whole if something goes awry.
The tighter reading wins
When the two readings disagree, you do not average them. An average of a stomach and a balance sheet is not a theory. It is a way to feel sophisticated while ignoring the binding constraint.
The tighter reading is the ceiling.
If the plan cannot take a twenty-percent hole without raiding the emergency funds or moving the retirement date, capacity is the ceiling — no matter what the questionnaire said. If the plan can take the hole and you refuse to sit through it, appetite is the ceiling — no matter how pretty the reserve looks on paper.
The one table
| Appetite | Capacity | |
|---|---|---|
| Question | Will you sit through it? | Can the plan sit through it? |
| Object | Stomach. Preference. The coin you will not abandon. | Horizon, cash, job, house, spend date, max hole you will not raid reserves to fill. |
| Fails when | You sell the dip you said you would buy. | A ugly year forces the emergency sleeve or the retirement date. |
One object. One table. That is the job.
A household, not a product
Remember you’re a household; you’re not a product. Industry sees you as the latter not the former.
Later we’ll determine your degree of risk-aversion. Sure, there’s more math but you might find something about yourself you didn’t know before.
First order of business is to determine your household balance sheet. The next set of questions is what you need to ask
- What’s your net worth? How much are your Assets? How much are your liabilities
- From your total assets, how much of that is cash, cash equivalents, or investments? How much of that is in a tax-deferred account? How much of it is in an after-tax Roth IRA? How much of it is in a taxable brokerage account?
- Do you own a home? Do you have a mortgage? If so, how what is the mortgage balance?
- How much debt do you have?
- What’s your current salary? How long do you have until retirement? Do you have a pension? What about social security?
These are questions you need to be asking anyway because a household that watches its balance sheet demands it.
What this is not
This is not a measurement. Not yet. We have not asked you to switch from a safer sleeve to a wilder one. That is next.
This post is a lead up to that. Keep this post in mind when we get to it. Go back to my earlier posts here and here to help put things in perspective.
This is not advice. It’s to demystify the term risk tolerance. The industry calls it that way because it is easier to sell than two constraints. We are not in that business.
Next
Willingness can be measured with a clean set of tickets. That’s the quiz. Ability can be measured against the plan.
Stay tuned!
