This post has been cited in the Money Hacks Carnival #79, hosted by Modern Tightwad.
This is the fourth in a series of posts on investment planning. For those who haven’t read the first post (or have forgotten), I’m soliciting feedback (tips, tricks, links, etc.) that I will cite and use in the final post of the series. Here’s a list of the other posts in the series:
- Investment Planning: The Series
- Household Budgeting the Easy Way
- Budget Tracking and Projections (with Quicken Tricks)
- Willingness, Ability, and Need [this post]
- Estimating a Retirement Budget
- Need for Risk: The Details
- Multi-Period Planning and Asset Allocation
- Investment Planning: Reader Tips, Tricks, and Links
It is standard advice that one should only take risk commensurate with one’s willingness, ability, and need. But what does this really mean? I am not satisfied with the definitions I have found elsewhere (to the extent any are given) so I thought it through for myself. Here’s my take.
Willingness is all about a gut feeling of comfort. It is a non-quantitative concept. A common test for willingness to take risk is the “sleep test”. If you can’t sleep at night because of an investment decision, either actually made or in consideration, then you may have exceeded (or are considering exceeding) your willingness to take risk. On the other hand, if your decisions do not cause you unrest, your investments are probably in line with your willingness for risk.
Thus, willingness to take risk reflects your level of comfort with loss of your investment. For instance suppose you’re considering investing $10,000. Your willingness for risk is how readily you would take the chance of losing some of it for the chance of earning an expected profit. For example, you might not be comfortable taking the risk of a 50% probability of losing $5,000 (half the principal) in exchange for a 50% probability of earning $10,000 (doubling the principal). But, perhaps you might readily risk a 25% probability of losing half for a 75% probability of doubling it. Your willingness for risk is exceeded in the first example but not the second.
While your willingness for risk may be vague, your ability to take risk is quantifiable. It is based on your budget (if you don’t have one, see my prior post on the topic). To be able to take risk you have to have something you can afford to place at risk. Thus, your ability for risk is your surplus, i.e. your income less all necessary and regular expenses. By definition you do not require your surplus to support your current lifestyle. If you do, then you haven’t constructed a proper budget.
(By the way, I am assuming you already have an emergency fund of appropriate size and no high-interest debt. Having an emergency fund and ridding oneself of high-interest debt are prerequisites. Some would argue putting emphasis on ridding oneself of all debt, event low-interest fixed-rate mortgage debt. That’s debatable and I’m not taking that position here. You may decide for yourself.)
Like ability, need for risk is quantifiable but the process of doing so will take many more words to develop. In short, your need for risk is based on your future requirements for money. Some of these requirements are large and a long time from now (e.g. retirement) so pinning down their relationship with risk is tricky (and is the topic of many books and a large industry). Need for risk, more than anything else, drives one’s required asset allocation. Subsequent posts in this series will delve into this further into this topic.