June 6, 2022

Risk Appetite vs Risk Tolerance: How They Should Impact Your Portfolio


The typical portfolio allocation today looks vastly different to how it did 10, 20 or 30 years ago. Aside from the different asset classes that are now available, the gamification of stock market and trading apps and the rise of social media has opened up investing to a new generation. Which is a good thing, right? Of course it is. One of the main criticisms in the past of the stock market and investing more broadly is that it is only accessible to those who have money and resources already. And this is changing: 15% of the retail market is now made up of investors who started in or after 2020. But more assets mean more choice - it can be incredibly overwhelming when logging into any investing app to make a decision on what to buy. It all boils down to the understanding and  acceptance of one key question: how much risk are you going to take? More explicitly - what is your capacity and tolerance for risk. These will dictate what assets you buy.

How should retail investors choose assets?

There have been a number of knock ons of these changes for the broader market. Let’s go deeper. The first, and most serious, is that since Covid-19, investors have grown used to a market where everything goes up, and at a staggering pace. Yes, some of this is down to cryptocurrency gains but we’ve seen ridiculous growth from blue chips like Tesla and Nvidia, and IPOs from companies who haven’t even made a cent of revenue. This means that people are no longer satisfied with the steady, glacial growth of the S&P 500.

Despite the fact that it’s up 27% YTD we haven’t heard a peep of it in several years. This is a bad sign — reaching a point at which people think they know better or are too advanced for index investing on a mass scale is usually around the time things start to pull back. It also means that portfolios are overweighted towards riskier assets that have done well over this 5 year cycle, but are certainly not guaranteed to do so in future. The other problem is that these assets have grown at such a weight that they now take up more than intended of an average portfolio. This has the common effect of leading retail investors to thinking that they have the appetite for riskier asset classes, given that they've only seen them go up in recent memory. However, this bias leads them into the business of investing in things that are well beyond their remit. With some strategic planning and understanding of objectives, this can be avoided. Let's look at the management of your own risk.

Risk Appetite

The first thing to consider is your appetite for risk, and this is quite a personal question. The first thing to ask yourself, is how comfortable are you with temporary falls in the value of your assets? Would a fall of 20% keep you up at night and cause you undue  concern? How about 30%? 40%? It is the regulation of assets in your portfolio that will dictate this, so it's something to note. So what directs risk appetite? It's not something that a computer program can spit out, or you can reel off at will. It requires some thought, and perhaps some practice investing in a range of assets with smaller amounts. A large part of it is personality, but education also contributes - from your school days until the job role you fulfil now, and the business process you encounter day to day. Training and practice can affect this, but part of it will just be how you are. The sooner you come to terms with this and get comfortable with it, the sooner you can continue to invest in your own style in relative peace. Do not mistake this for skill - it gets its own treatment, and for good reason.

Risk Tolerance

The second thing to consider is your risk tolerance. How much risk are you physically able to take. How large is your portfolio and how much do you need the cash in the short term? Do you have a family and a mortgage that need funding? Are you close to retirement? A young graduate will be able to bear much more risk, with 40y+ for their portfolio to recover, than someone close to retirement who will need to liquidate assets soon, or the head of a family who will need to pay for their child's education. How hungry you are for growth is a misleading statistic, as are previous returns and what you think might be best. Simple qualitative research can help dictate where you fall on either of these scales, and there are an abundance of online questionnaires you can download to help you.

Once you've decided on an asset pool you feel comfortable with, portfolio trackers like the Strabo dashboard will help you with measurement of their performance, as well as industry standard metrics. Even in recreation, you'll be able to keep an eye on your allocation and know when to rebalance to stay in line with your preset goals


So what does this mean someone looking at their portfolio today should do? The traditional investing canon used to suggest an equity-bond split by age, where a 32 year old would have 32% bonds and the remaining 68% in equities, and so on up until retirement. This would change your risk profile as you moved through life, and thus had less time to recover from the sporadic economic shocks that can result in longer term pullbacks. However, a number of things are making this a little outdated. Firstly, bond markets are no longer providing the returns that they used to, and secondly people are living much longer, giving them more time to recover from price dips.

Here at Strabo, we like to hold predominantly equity funds, with a small portion of the portfolio dedicated towards self-selected individual stocks and alternatives within the law like cryptocurrency and venture capital investments. This means we can scratch the itch of self selecting stocks, while leaving the majority of our portfolio to rumble along passively with the market. After all, more than 80% of even professional investors fail to beat the market. Although favour has been with retail of late, the pendulum will soon swing back towards passive strategies as we eventually return to a bear market. In the august words of George RR Martin, Winter is Coming! This is similar advice to that you will hear from a seasoned industry practitioner.

So what?

With this in mind — by all means enjoy tech and crypto investments, but try to hold a strong exposure to the broader markets and economies including US, European and emerging. These will be back in favour once the current madness subsides, and will serve you well with no stress or decision paralysis. Pound or dollar cost average into these monthly, and you’ll build yourself a good nest egg for retirement. Specific percentages are hard to dictate given it’s dependent on individual circumstances, but for anyone in young to middle age, a vast 80–90%+ equity allocation, the majority of which is passive (or wholly if you lack experience or desire to invest individually), is the most sensible options. Please do reach out with any questions, or simply to share your investing strategy! And whatever you do, don't forget to manage your allocation with Strabo!

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