The Efficient Frontier: How Much Risk Can You Stomach?

HRE PR Pic 2013

Harold Evensky CFP® , AIF® Chairman

Anchoring on the efficient frontier may sound like something out of Star Trek, but it’s not. It’s better.

Harold Evensky (HE): Mr. and Mrs. Curtis, good morning. I’m Harold Evensky and this is my partner, Matt McGrath. Welcome to Evensky & Katz. I always like to start by asking, “What brings y’all here?”

Mr. Curtis (Mr. C): Well, Harold, Vickie and I are thinking about retiring in just a few years. We’ve saved quite a bit and think we’ll be in good shape, but we had some friends who retired a few years ago, who thought they were in good shape only to discover that things didn’t work out quite as well as they expected and they’ve had to do some major cutting back in their lifestyle. We don’t want that to happen to us. The Hamptons said you helped them do some planning for their retirement so we thought we’d like to work with you to do the same.

HE: Wonderful. Let’s have some fun envisioning your future. And that’s the key—it’s your future. Our job is to empower you to plan that future. Suppose we start off with an introduction: “Modern Portfolio Theory and You.” Matt, may I have a blank sheet of paper from your pad? Thanks.

Here’s a simple picture of the investment world. On one axis, we’ll plot risk and on the other, return.

The Efficient Frontier Chapter Image file - .01.png

As you’d expect, cash would not be very risky, but it would not provide much in the way of return, whereas stock might provide a high return but at some risk. Bonds are somewhere in between.

With just these three choices, we could still design thousands of portfolios. For example, 99 percent bonds and 1 percent stock or 99 percent stock and 1 percent bonds. If I put dots on my graph for the risk and return combinations of all of these combinations, I’d fill up the picture with dots. Then, if I drew a line enclosing all of those dots, I would end up with a curved line that’s called the efficient frontier.

The Efficient Frontier Chapter Image file - .02

That means, at least theoretically, there is no best portfolio but rather an infinite number of best portfolios, depending on the risk one is willing to take. We know that everyone would like to have a portfolio with no risk and lots of return. Unfortunately, the real world of potential portfolios lies on or below the efficient frontier. So what does that mean for you?

Well, it means we have to do some planning, and then you’ll have a decision to make. First, as I said starting off, we need to make a best guess as to what return your portfolio would need to earn over time to provide you the money you need to accomplish all of your retirement goals. Then we need to make a best guess as to your risk tolerance. If we just focused on your return needs, we might conclude it was possible to achieve your financial goals with a portfolio allocated 90 percent to stock. But that might not work out very well if we faced a major bear market in a few years. After you saw your nest egg lose 40 percent, you’d call us and say, “Harold, we can’t stand it. Please sell our stock and put our money in cash!”

That’s why we define risk tolerance as the point of pain and misery you can survive—with us holding onto your belt and suspenders—just before you make that call to tell us to sell out.

With those two anchors, we can now revisit our graph. Suppose the results look like this.

The Efficient Frontier Chapter Image file - .03.png

We have two portfolios for you. Portfolio A is one that provides the return you need to achieve your goals, and B is one in keeping with your risk tolerance. Which one is right? In fact, both are, but our recommendation is to plan on Portfolio A. Why? Even though we believe you can live with more risk and would end up with more money, determining risk tolerance well in advance of a terrible market is more art than science. The consequence if we’re wrong and you bail out of the market that would be catastrophic. So why take that extra risk if you don’t need it to achieve your goals?

How about if we found a different outcome? Suppose we concluded that you needed Portfolio A to provide your needed return but had a risk tolerance associated with Portfolio B in this picture.

The Efficient Frontier Chapter Image file - .04.png

That’s not very good, because now you have to decide between eating less or sleeping less. In this case, our recommendation would be to readjust your goals to meet the return expectations of Portfolio B. Why? Again, when markets seem okay, it’s all too easy to say, “I’ll take a bit more risk.” But later, when it seems the world is coming to an end, you’re not likely to remember your willingness to hang in there.

This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.

What is your risk tolerance?

Brian Fischer

Brian Fischer, CFA, CFP® Financial Analyst

When I think of risk and the markets, I’m reminded of one my favorite Mark Twain quotes:October: This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February.” Although I can’t help but laugh, I don’t doubt that some people feel this way about investing. It’s easy to think of the market as highly speculative when recalling the turmoil of the dotcom bubble in 2001 or the subprime housing crisis of 2007-2009. Pile on the around-the-clock media coverage of the market’s every move that at times stokes feelings of apprehension, and suddenly the thought of risk and investing can be frightening. Fear of risk even seems reasonable. On the contrary, it’s very dangerous. Unhealthy attitudes and beliefs about risk can prevent you from investing in a manner needed to achieve your goals. Stated differently, a proper understanding of risk and, more importantly, knowing your risk tolerance is essential to creating a viable financial plan.

What is Risk Tolerance?

To understand risk tolerance, we first need to distinguish it from risk capacity. Risk tolerance can be thought of as your willingness to take risk. It comprises your attitudes and beliefs. Risk capacity, on the other hand, is the ability to take risk or withstand losses. It is your resources relative to your goals.

… tolerance relates to an individual’s emotional limit of acceptable risk; capacity refers to the financial capacity to withstand market losses. These two factors are not necessarily correlated. For example, it is not uncommon to find an investor with significant assets and modest demands on those assets such that a significant market loss would not affect the ability to maintain the individual’s desired quality of life. (i.e., high risk capacity). However, that same investor might be unwilling to invest any significant portion of the portfolio in stock and might well bail out of whatever stock allocation there was in a significant bear market (i.e., low risk tolerance). As a consequence, questions regarding capacity are more important for general planning purposes but are not relevant for evaluating tolerance.1

When markets are doing well, risk is irrelevant and risk tolerance is infinite. It’s only when the market is falling that risk becomes important. Investors too often make the mistake of panicking in a bear market and selling their investments at depressed prices. They effectively buy high and sell low, and lock in losses that can be irreversibly detrimental to their financial plan. For that reason, we believe the most practical definition of risk tolerance to be the moment right before you call us and say, “I can’t stand it anymore; sell me out.”

How do we evaluate risk tolerance?

While we use a well-known and widely-used traditional risk survey, FinaMetrica, most of our evaluation is done through our conversations with you and our Risk Tolerance Questionnaire (RTQ). Although the RTQ is a formal questionnaire that can be completed individually, we work through it with our clients and use it as an educational tool to facilitate discussion about how each of us thinks about risk and investing.

Our entire process is grounded in the idea that each of our clients has a unique perspective about risk. To understand these perspectives, we use the insights into behavioral finance to provide explanations for why people make the decisions that they do.

People are strange. There is no more apparent example than the psychology of risk. People in general and clients in particular have difficulty distinguishing between knowledge-based risk and foolhardy speculation. As an example, investors grossly overestimate their knowledge and, even when provided with good data, they are poor mathematicians of probability.

Investors also have difficulty estimating the risk of future events. They are much more comfortable with short-term events in which they have more intuitive confidence in their knowledge. This results in a tendency to overstate their personal risk-taking propensity.2

Behavioral finance recognizes that we have limitations in processing large amounts of information, thus impacting our decision making. To overcome these limitations, we use heuristics to simplify decisions. Heuristics are mental shortcuts, also known as rules of thumb, based on our experiences. They are helpful in making quick and adequate decisions, but can also lead to biases that result in harmful decisions when used inappropriately.

By understanding the nature of heuristics, [we are] able to better understand the underlying issues influencing a client’s risk tolerance. Also, [we are] more effective in assisting [our clients} to modify misleading heuristics, as well as becoming a better educator and guide [for] our clients in the useful application of these mental shortcuts.3

A common heuristic that creates a harmful perspective about risk is the availability bias. This mental shortcut uses recent and easily recalled information to draw conclusions. A classic example of this bias is described at the beginning of this essay with an individual who is fearful of risk because he or she easily recalls bear markets and is engulfed in the around-the-clock media coverage of market volatility. By addressing this bias and any others that may be harmful, we help our clients form reasonable perceptions of risk. Finally, with a common understanding of risk we can then properly evaluate risk tolerance and invest in a manner to which our clients are most likely to remain committed.

Identifying and working through the flaws in emotional thinking helps us avoid common traps that create harmful or unrealistic expectations that hinder us from achieving our goals.

Feel free to contact Brian Fischer with any questions by phone 305.448.8882 ext.235 or email: BFischer@EK-FF.com

  1. Evensky, Harold, Stephen M. Horan, and Thomas R. Robinson. The New Wealth Management: The Financial Advisor’s Guide to Managing and Investing Client Assets. Hoboken, NJ: J. Wiley, 2011. 57.
  2. Evensky, Harold, Stephen M. Horan, and Thomas R. Robinson. The New Wealth Management: The Financial Advisor’s Guide to Managing and Investing Client Assets. Hoboken, NJ: J. Wiley, 2011. 59.
  3. Evensky, Harold, Stephen M. Horan, and Thomas R. Robinson. The New Wealth Management: The Financial Advisor’s Guide to Managing and Investing Client Assets. Hoboken, NJ: J. Wiley, 2011. 59.