As a kid in the ’80s and ’90s I remember begging my parents to buy VHS copies of Terminator and Predator. Who didn’t love Arnold Schwarzenegger?
It’s easy to forget he got his start bodybuilding. That it was only after winning seven Mr. Olympia titles he wanted to be an actor, and it was only after becoming a bonafide action-film superstar he wanted to be governor.
I’m thinking nobody has three huge careers because it’s the safe path through life, and so he must have a very high risk tolerance. This can only be learned through trial and error.
It was little surprise then to discover he’s a long-time investor. From Tools of Titans:
“I felt if I was smart with real estate and took my little money that I made in bodybuilding and in seminars and in selling my courses through the mail, I could save up enough to put down money for an apartment building.
I quickly developed and traded up my buildings and bought more apartment buildings and office buildings on Main Street down in Santa Monica and so on. I became a millionaire from my real estate investments.”
Schwarzenegger’s life is a fascinating example of exposing yourself to risk and getting rewarded for it. After all, that’s what investing is. You get rewarded for exposure to risk.
That’s why I’m always amused when people ask how they can turn $100 into a fortune without losing a dime. If there was a way to make money hand over fist with no risk wouldn’t everyone on the planet be rich?
In reality, there’s only two sides to investing in the market:
- Stocks are ownership in a business, with no guarantee of success.
- Bonds are loans to such a business (or government), with no risk other than the risk they go bankrupt.
How you approach constructing a portfolio of stocks and bonds is how most investors control risk and reward.
The rule of thumb is to invest your age in bonds. Meaning, if you’re 30 years old you put 30% in bonds and 70% in stock. At 70 you put 70% in bonds and 30% in stock. To say that another way, as you age you’re gradually shifting money from stocks to bonds. From more risk to less, from growth to safety.
But the problem with any rule of thumb is just that, it’s a rule of thumb.
What “age in bonds” fails to account for is personal risk tolerance. For instance, what happens when a 30-year-old who’s brand new to investing puts 70% in stock and then watches the market fall 50%? It’s very hard to sit idle while 35% of your life savings evaporate.
So it doesn’t really matter what your age is, because what matters is your personal risk tolerance. In The Investor’s Manifesto author William Bernstein recommends the following modifiers to “age in bonds”:
- Very low risk: +20%
- Low risk: +10%
- Moderate risk: 0%
- High risk: -10%
- Very high risk: -20%
Here’s how to use these numbers. A 30 year old who has a “very low” risk tolerance — terrified of losing money — adds 20% to their “age in bonds” number. Instead of 30% bonds and 70% stock their new mix is 50% bonds and 50% stock.
On the other hand, consider a 70 year old with millions of dollars they’ll never spend down. They can afford a “very high” risk tolerance, and subtract 20% from “age in bonds.”
This is how 30- and 70-year-old investors can have the same 50/50 mix. Make sense?
The problem isn’t that seasoned investors don’t know what their risk tolerance. They do. The problem is when you’re just starting out and have no clue, and the way to approach this dilemma is to imagine how you’d feel if you lost or gained money. In fact, that’s what Harry Markowitz, who won the Nobel Prize for exploring the tradeoff between risk and reward, said about his own portfolio:
“I visualized my grief if the stock market went way up and I wasn’t in it — or if it went way down and I was completely in it. My intention was to minimize my future regret. So I split my contributions 50/50 between bonds and equities.”
When you don’t know what your risk tolerance is maybe your best bet is to start with 50% bonds and 50% stock.
And speaking of betting, the best poker players know if they sit at the table and only play “the nuts” — hands that can’t be beat — they won’t play hands with a good chance of winning. The point is, if you insist your portfolio needs to be a sure thing then you’re naturally going to be risk averse, and being risk averse means accepting low returns.
Safety is fine, just be aware risk gets the rewards.