Since 2009, one of the things I have focused on is trying to help readers have a risk-appropriate asset allocation. A risk-appropriate investor invests according to their true risk tolerance. When you invest according to your true risk tolerance, you usually become a calmer, wealthier person.
Over the long run, your investment asset allocation is highly rational. You will make adjustments during various economic cycles until you reach the point where you feel fine no matter the environment.
In other words, you will discover your true risk tolerance through experience and intentional financial planning. As your financial situation and goals change, so will your asset allocation.
Understanding your true risk tolerance may take between 10 – 20 years. Therefore, it can be dangerous to only listen to someone who has only invested during a bull market or bear market. Over the past 27 years of investing, I’ve discovered we often overestimate our risk tolerance.
To make financial adjustments, you must be in tune with yourself. It’s worth being immersed in the world of personal finance by subscribing to newsletters, listening to podcasts, and reading books.
After a year of not checking your portfolio, it is easy to misremember what you invested in and how much. Please don’t get blindsided by a bull or bear market because you thought your asset allocation was one way when it really was not.
A Risk-Appropriate Asset Allocation In A Bull And Bear Market
During a bull market, if you have a risk-appropriate asset allocation, you will feel good knowing your net worth is invested in enough risk assets to benefit from a strong economy. Thanks to your discipline, investing FOMO doesn’t overwhelm you to abandon your asset allocation for much riskier assets than you can really take.
The only time your asset allocation would become riskier is if your risk tolerance has materially increased due to a sudden financial windfall. Or you may become more bullish on your income potential or managing your future expenses.
During a bear market, if you have the right asset allocation, you are relatively at peace because you know drawdowns are a part of investing. Although it still stings to lose money in a bear market, you feel comfort knowing your realistic net worth downside potential.
With a risk-appropriate asset allocation, you outperform your peers who blow themselves up in a bear market. As a result, you are winning since everything is relative in personal finance.
Veteran Investors Know Their Downside Risk
Based on history, the average drawdown in the S&P 500 is about 35% and lasts about between 12 – 15 months. The average historical returns for the S&P 500 since 1926 is about 10%, with dividends reinvested.
For real estate investors, you also understand the risks involved. During the global financial crisis, the median sales price of houses sold in America declined by about ~19% from 1Q 2007 to 1Q 2009. The average returns for real estate is between 1% – 2% above the average inflation rate.
The Easiest Way To Know Whether You Have The Right Asset Allocation
It takes trial and error to find the proper asset allocation that fits your risk profile. As a result, an investor likely needs to go through two economic cycles to find their risk-appropriate asset allocation.
But an easy way you can tell whether your asset allocation is inappropriate is if you find yourself getting overly emotional during downturns or overly exuberant during upturns.
For example, if you find yourself losing patience with your spouse and kids more often when stocks are going down, it’s probably a sign you’ve invested too much in stocks. Losing money from your investments shouldn’t negatively affect your relationships with people who have nothing to do with your investment choices.
More Clues As To When You Have An Inappropriate Asset Allocation
If you find yourself binge eating and gaining weight or drinking heavily during a bear market, your allocation to stocks is probably too high. Same thing goes for if you start experiencing chronic back pain or other physical ailments out of the blue. Your body provides great warning signs if you pay attention.
On the flip side, if you find yourself hugging and kissing everyone more than usual when the S&P 500 is up three percent when the average daily percent move is one percent, beware! You’re likely counting too much on your investments to reach your goals. Bigger emotional highs tend to lead to bigger emotional lows.
As an investor, the emotions you experience shouldn’t be above or below your normal emotional band. Otherwise, adjustments are in order. Ideally, your investments are shifted to the background so you can focus on enjoying your life.
Examples Of Emotional Explosions
One of the benefits of operating a personal finance site is getting to read everybody’s comments whenever I write a post. I can often tell someone’s state of mind because they are clearly reflected in the way they comment. Readers can also understand my state of mind based on the way I write my posts.
In How To Enjoy Your Life After The Fed Ruins The World, I decided to make lemonade about an unfortunate situation. As a personal finance writer, I like to have an opinion, create imagery, and provide solutions. The post’s main goal was to help us accept the reality of a global recession and make the best of it.
But because the post got picked up by a reading app called Flipboard, over 10,000 new readers who are unfamiliar with my background read my post. And some of the comments were very emotionally charged and full of political references, when the post was not political at all.
Financial Fear Makes Angrier People
Happy people don’t go bashing people over social media and in the comments section of articles. But based on the reaction to that article, it seems like there is a lot of fear out there at the moment. The fear of losing a lot more money and the fear of your political party not winning the mid-term elections.
Investors who commented courteously likely have risk-appropriate asset allocations. Below is an example of my New Life Net Worth Allocation. By age 40, one takes on a “new life” be going beyond making money from their day job.
Translate Money Into Lost Or Gained Time
I have attempted to quantify your risk tolerance by introducing FS SEER. SEER stands for Samurai Equity Exposure Rule. The concept should eventually take off because it is completely rational.
Why do we invest? To potentially make more money passively. Why do we want to make more money passively? To do more of the things we want and less of the things we don’t. Why do we want more freedom? Because time is limited. We can always make more money, but we can never make more time.
Therefore, you can quantify your risk tolerance by calculating how much TIME you are willing to spend working to make up for your potential losses. The longer you are willing to work to make up your losses, the more risk loving you are and vice versa.
FS SEER Formulas To Quantify Risk Tolerance
Risk Tolerance Multiple = (Equity Exposure X 35%) / Monthly Gross Income
The Max Recommended Equity Exposure = (Your Monthly Salary X Risk Tolerance Multiple) / 35%
* 35% is the average bear market drawdown. The 35% can be adjusted based on your drawdown forecast.
Have a look at my FS SEER risk tolerance chart. It states that once you are willing to spend 24 months of your life making up for your loses, your risk tolerance is high. It says you are a conservative investor if you are unwilling to spend more than 6 months of your life making up for your potential losses.
The FS SEER formula can then be used to calculate your recommended equity exposure maximum based on your income and risk tolerance.
For example, if you have over $1 million in equities with a $10,000 monthly gross income, you are considered to have an extreme risk tolerance. You are OK with spending 36 months working to make up for your potential equity loss of $360,000.
If you make $10,000 a month and feel you have a moderate risk level, then having $342,857 to $514,286 in equities may be appropriate. Play with the formula and variables yourself.
Where Is My Nobel Prize In Economics?
Whether you agree with the variables in my formula or not, the framework is there to help you become a more risk-appropriate investor. Time is more valuable than money.
Maybe you think having an Extreme Risk Tolerance is being willing to work 120 months to make up for your losses. If so, your Risk Tolerance Multiple jumps to 120 from 36. For a $10,000 monthly gross income, the maximum equity exposure you are recommended to have is $3,428,571 ((120 X $10,000) / 0.35).
Personally, I’m unwilling to spend more than 12 months making up for investment losses. Therefore, I consider myself a moderate-to-conservative investor. I’ve got less than three years until my daughter attends school full-time. Hence, I need to make the most of it.
I see no tenured professors with PhDs at the most prestigious universities coming up with such a practical formula for millions of investors. Instead, there are numerous research papers with complex formulas the average person will never read or utilize.
It doesn’t matter how great an idea is if it is not easily implemented. Theory is not as important as practice!
Real-World Experience Matters When Investing
Should I be considered smart for coming up with something unique, simple, effective, and practical? Of course not. I came to America at 14 and attended public schools. The only way I could have created this helpful formula is through firsthand experience.
Losing money during the 2000 dot com bubble was difficult. So was investing for a whole decade and not seeing much in total returns. So I made adjustments by investing more in real assets.
Seeing 35% of my net worth that took 10 years to accumulate disappear in six months was very painful. But the 2008 global financial crisis taught me to not extrapolate my income or returns far into the future. The crisis also reminded me about the importance of diversification and to not confuse brains with a bull market.
As a practitioner of early retirement since 2012, I’m experiencing firsthand what it’s like to not have day job income. The scarcity of time is one of the main reasons why I negotiated a severance at 34 in the first place.
Retiring early was a hedge against dying early so I could live my life with the least number of regrets.
Your Rationality Will Eventually Get You To An Appropriate Asset Allocation
One of the best things about being human is that we are all long-term rational. In the short run, we will experience mistakes. In the long run, we learn from our mistakes and make wiser decisions.
We won’t keep making the same mistakes over and over again. Otherwise, we’d be insane! Instead, we will either learn from our mistakes or learn from people who’ve been through what we may go through.
If you are feeling highly emotional during this latest bear market, then accept you have an inappropriate asset allocation. You will either have to lower your exposure to risk assets by selling some assets or saving and investing more in lower-risk or risk-free assets, or both.
My favorite way to reduce the percentage of risk assets to overall net worth is by raising more cash and buying more Treasuries and other lower-risk investments. I don’t enjoy selling stocks or other risk assets after they’ve collapsed. Because eventually, such assets tend to recover.
My Latest Asset Allocation
Since 2003, I have preferred real estate over stocks. Seeing stock fortunes disappear overnight in 2000 made me seek wealth in real assets that are much less volatile. As a result, roughly 50% of my net worth is in real estate and 30% of my net worth is in stocks today.
I did have about 35% of my net worth in stocks and 54% in real estate before the bear market altered the percentages. 30% is my stock allocation limit because I can’t stand losing more than 10% of my overall net worth from stocks.
Losing money in stocks still stings. But it’s not painful enough to negatively affect my mood for long or alter my daily life. Stocks would have to fall by 70% from peak to trough for me to consider going back to work.
The value of my physical real estate portfolio is almost irrelevant due to the lack of debt. I primarily own real estate for shelter and semi-passive income. I plan to hold my properties forever.
Every time we go through a bear market, I’m reminded of how useless owning stocks is if they don’t pay a dividend or if they are not occasionally sold for profit. Please don’t forget to enjoy your gains once in a while!
Buying Stocks And Bonds In A Bear Market
I’m nibbling on the S&P 500 down 25% as I mentioned in my post on how I’d invest $250,000 cash. But I’m also happy to buy Treasury bonds yielding 4.2%+, which has helped boost our passive investment income to ~$380,000.
Finally, I’m on the hunt for another sweet property within the next 24 months. I think there will be better property deals given the Fed has aggressively hiked rates and plans to keep them high for a while.
With a risk-appropriate asset allocation, I’m able to better focus on spending time being a father and a writer. If I find myself unable to freely do these two things, then I will change my investments accordingly.
Questions And Recommendations
Readers, how have you found your risk-appropriate asset allocation? How long did it take for you to get your portfolio aligned with your risk appetite? What is your net worth asset allocation look like?
If you’re looking to surgically invest in real estate, take a look at Fundrise. Fundrise is a vertically integrated real estate platform that invests predominantly in Sunbelt single-family properties. Private real estate is a good way to diversify and earn income 100% passively. I’ve personally invested $810,000 in the space.
To gain an unfair competitive advantage in building wealth, read Buy This, Not That, my instant WSJ bestseller. It was written exactly for volatile times like these. As others blow up their finances with an inappropriate risk tolerance, you’ll navigate the rocky waters better.
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A couple of thoughts I had while reading this and looking at some of your cash flow sources (way to go btw and I definitely will be doing a YouTube video on this!):
With this equation, and someone eluded to it, how do you view the amount of cash you have on the sidelines? Maybe someone has 1M in stocks and would be classified as extremely risky by this formula but they may have 10M in cash sitting on the sidelines.
Is this formula saying we should only be looking at our equity portion that is NOT paying dividends?
I, like you, have a lot of my net worth in real estate (almost 80% before getting married and now about 65%). I’ve started diversifying a bit in terms of types of rents and geography (have 12 LT rental units in MI but acquired a ST rental in SC) but have started thinking we may still be too concentrated in real estate, at least US real estate (gd forbid something were to happen to America as a whole). Are you at all concerned having a lot of rentals in San Fran?
Thanks for the thoughts and I don’t see why you shouldn’t throw your name in the ring for the Nobel Prize!
Financial Samurai says
In terms of cash, I think we should all have a steady state cash supply of between 6 to 12 months of living expenses. Our cash will fluctuate as our income, spending fluctuate as well.
Literally, if we have a tremendous amount more cars than normal, we can take more risks in the equities market or any risk assets. I have to think more about this. If you have this much cash, let’s say $10 million, and only 1 million in equities, then you likely had a windfall or a transaction. And your expenses are more than covered for a long long time based on your cash balance.
The formula includes equities that pay dividends and don’t pay dividends. The idea is to get a proper risk exposure based on downside risk.
I generally don’t advise having more than 50% of your net worth and one asset class. I’m not worried about my San Francisco real estate portfolio because it’s less than 50% of my net worth and there is minimal amount of debt. Three of the properties are paid off, so they are just cash cows.
Very insightful post Sam, I have loaded up on Dividend Producing stocks over many years and now they are down upwards of 20-30 percent. But the cashflow is the same, and its being reinvested anyway, so I’m getting shares at cheaper prices. So, even though my wealth on paper looks like it’s fallen off the map, the reality is it hasn’t because I haven’t sold anything.
I think I come at risk alittle different. I consider myself low to moderate risk even though I have 80% of my net worth in equities, about 4 out of 5 million.
I say this because I keep 500k in cash. That is 3-4 years of living expenses. So Sam, as you have frequently stated, that essentially prevents me from having to sell assets at a deep loss, assuming the historical length of bear markets holds up (3 months to 3 years).
I am low risk because I do not want to be forced to sell (or go back to work) whatever happens in the stock market. However I am also not interested in maintaining houses and want to benefit from market upsides, all the while understanding I am horrible at timing. I do have my house paid off and no debt, so most important thing for me is to be in the market and at the same time protect against stock market risk.
As such, the “Net Worth Allocation by Age – New life”, I am not sure how to approach. Is that assuming one month of bills covered? 6 months? Where is the cash buffer – under “Alternatives?”
My risk tolerance is extreme according to your chart. I thought I can handle the volatility because I lived through the dot com bubble and the global financial crisis. Our net worth is down 18% so far this year. That’s less than during the financial crisis, but the dollar amount is much more. It’s unsettling. Now, I realize my risk tolerance is more conservative as I get older. I’m fine with hanging on until the stock market recovers this time. But I’ll reduce our equity exposure a ton to prepare for the next bear market. You don’t have as much time to recover when you’re older.
I think Sam’s framework is one of many good data points to determine risk level.
I would add instead of just thinking my allocation should be x because this is my personal feeling and then rebalancing on a periodic schedule towards x, one might also make it conditional and say there appears to be a lot of market risk in y market right now so I will adjust my allocation to x.
To put it another way, given the cross currents in the market right now, a more active strategy may be a better course.
“The concept should eventually take off because it is completely rational.”
It’s nice to see you dip your toes into writing comedy :-D
I think there is a lot of wisdom in this.
Financial Samurai says
How do you know I’m not already? Ah hah! Do what you like and what you are good at. And don’t ever tell the world so you can live free.
Manuel Campbell says
I’m still 100% equities. And feeling more and more grumpy in this very tough market !! I’ve been through the tech bubble and the financial crisis, so this is my third economic cycle I’m going through. We will see if I can still stand the “extreme risk tolerance” according to the FS SEER guide. Maybe I will have to review this position after this one. But for now, it had worked well for me in the past. So, I hope I will be ok this time again.
I understand the fear for loss of capital. But for me, inflation is still the biggest threat. And, that is, if we don’t experience a bout of hyperinflation ! We tend to think those kind of economic disasters are reserved for third-world countries and that our developped economies are immune to them. But what if they are not ? The “ultra conservative” equity exposure would then become the riskiest allocation of all.
I would like to know your view on the risk of inflation and how you think about it when you decide your asset allocation.
Also, I’m not sure why you exclude your investment real estate from you equity / stock allocation. I think they are very similar in nature, so they should be grouped together. The only difference being that you have full control over real estate that you own (100%) vs no control for stocks (~0.001% ownership).
Actual yields on bonds around 4% seems very attractive right now. But when you see inflation at 8.2% (sept 2022) and COLA adjustment for 2023 at 8.7%, it’s very hard to believe governments will be able to contain inflation. So, personally, I prefer to have my equity allocation at very high level. I just hope I’m not wrong about this.
Financial Samurai says
Curious what you think is your risk tolerance multiple based on my equation? You can find out but I just plugged it in your current equity exposure.
Related: Why real estate is less risky than stocks and the irony that follows
Manuel Campbell says
I would be around 36 “extreme risk tolerance”.
I think the risk with stocks vs real estate are equivalent, but different.
With stocks, you have volatility risk and “non control” risk (ie. the risk of being forced to sell at a price lower than what you would like to sell, during a takeover transaction for example).
With real estate, you have liquidity risk, ie. it can take a lot of time to sell a property. You can have difficulty to sell during a down market for example or you can miss out on an opportunity because of the time required to convert real estate into cash.
The way I cope with stock market risk is through higher diversification. For example, I try to keep single stock investing below 10% of total portoflio and 20% in a single sector.
Diversification also allows me to take advantage of higher stock market volatility. For example, at the top of the market bubble in 2021, I was able to reduce my exposure in tech (Tesla) and move to other safer and undervalued sectors, mainly in food and energy (Suncor, Couche-Tard).
Obviously, I’m down a lot on my portfolio like anybody else this year. But this allow me to keep my stock investments equivalent to the risk I would have if I had everything invested in the Canadian real estate market for example. So, I don’t think one is better than the other. They are just different …
Financial Samurai says
Fair points. I guess I don’t see as much liquidity risk because I never apply to sell my properties. The risk I feel is more on cash flow risk. I don’t really care what the values of my property are.
This is the beauty of investing. You can invest however way you want. It’s all good because everything is rational.
Entcho Todorov says
One of the best articles. I wish was 8 months ago.
Sport of Money says
I think I have a high risk tolerance when it comes to investing in stocks given (i) my current cash flow from investments, (ii) multi-decade investment horizon; and (iii) having excess cash for investments.
Similar to you, I am a big fan of real estate. I’ve built up a rental portfolio over a 15 year period. Currently, my net rental cash flow is enough to cover my expenses. Given the stability of my rental cash flow (battle tested between 2020 to 2021 during the pandemic), I can tolerate big swings in other portions of my investment portfolio.
My long term investment time horizon allows me to not focus too much on the short term movement of the stock market.
Also, having some cash in search of investment opportunities provides a silver lining to a market downturn. When given a choice, I would prefer to deploy my capital in a bear market than a bull market 10 times out of 10 – especially given my multi-decade investment horizon.
I am buying into this market all the way down, mainly a handful of dividend paying etf’s. My risk tolerance is medium, thus the etf’s and not single individual stocks. Elections in two years and if there is a changing of the guard, it will be up and away. Just my opinion. Stocks just want to go up, and they will in due time.
I think it makes a lot of sense to analyze one’s emotional state during volatile times in the markets. I’ve found a pretty happy comfort zone with my allocations but it took a while to get here.
But yeah I hear you on the fearful and angry people out there. It’s crazy how crass some people are when they comment. I can’t stand disrespectful people who attack others and take their anger out on complete strangers because they are unhappy with themselves.
First, cool idea Sam. Love it. The formula works “top down” and “bottom” up to check if you have an equity exposure that is in line with your risk appetite, although i think the top down approach is a little easier to wrap your head around than trying to quantify in terms of “months of working”. I’ll be a guinea pig:
High level facts:
-I am 40ish, single income, mid career, healthy W2, with 65% of my NW in MF real estate in a strong rental market. I have been weighted heavy toward cash recently, but have standard 401k, REITs (Fundrise!). In general i regard my real estate as wealth engine 1, my brokerage accounts as engine 2, and my 401k as engine 3, in that order. I am highly suspect of the height in equity run-ups, and think we are in for stagnant earnings for the next decade. Kind of a pessimist on the public markets, but also realizing that I might be very wrong in that conviction.
-My actual SEER (taking my Equity portfolio/AGI/12) is damn near a 10, which would indicate i am very reluctant to spend even 10 more months of work to cover my equities loss in a bear market. That feels low to me.
-My bottom up SEER (picking a SEER rating, multiplying it by monthly earnings), would probably be more like a 12. I like my job and can easily grind out another year of work to cover equity losses. more than that would be kind of depressing, even though i like my job (who wants to work super hard to stand still?).
According to your formula, i should be open to more equity exposure. Interesting. This is pretty accurate for me Sam.
The only thing I might quibble on is making the metric based on month. People tend to think in terms of years, not months, when thinking how long they can stick it out, especially since bear markets tack on years until retirement on the backend. Also, anchoring to a number like AGI on a tax return always feels like a metric that is rooted in something tangible.
Also, you probably know this, in HVAC a SEER rating is a rating of cooling efficiency, the lower the better. In a way, you are also rating efficiency, except you are attempting to model people’s utility of time as a function of equity exposure — which is also an efficiency of sorts.
Great article, solid metric Sam. Keep going.
Actually, I got that backwards, I’m HVAC a higher SEER rating is more efficient.
Simple Money Man says
Very insightful stuff. It’s nice to see 35% average downfall, I’m at a lower overall portfolio down percentage-wise than 35%; I guess that means I should take on more risk (easier said than done).
My portfolio is mostly Vanguard Growth ETF, then S&P ETF, a couple other sector ETFs and some single stocks.
But what about the flip side for investors? If they are feeling highly emotional during the bear market, they should look at past history and instead work on controlling their emotions, especially if they plan to keep their allocation same or similar for at least the next five years. Past history shows that this market should not last very long, relative to bull markets and we should continue to buy at lower prices.
My regret from experiencing two bear markets is that I wish I bought more stock.
Ms. Conviviality says
I really want to continue working on my goal of getting $300,000 in equities. With the stock market being so low, this seems like a great time to invest. However, I like real estate more so we are saving the cash for when real estate goes on sale which will probably be in a year or two. Always a constant dilemma of buy when stocks are on sale or when real estate is on sale.
I remember the boom/bust of 2008 like it was yesterday. I was young and single at the time, earning less than $30k/year but happy to have the job. I remember boiling my living expenses down to $1,000 month and being content. That scorched-earth expense figure would certainly be higher today, but I think it’s times like these where flexing the muscle of Resourcefulness really pays off.
I’m still working and plan to do so for 15 more years, so I’ll be riding this one out with my Extreme risk tolerance allocation.
Financial Samurai says
Curious, how many months would you classify extreme to be? I’ve got 36 months of work in my base chart, for Extreme risk tolerance.
I’m using your definition. Maximum equity exposure.
100% of my income comes from employment and will for the next decade, so while this downturn is testing my mettle from a net worth standpoint, my cashflow has not changed. I’m not rebalancing my current portfolio from stocks to something else, though it’s tempting, but I’m continuing to invest at a steady rate toward equities that are on sale.
Financial Samurai says
Got it. I’ll be curious to know if other readers have different definitions of extreme risk tolerance. I hope more readers can translate money into time saved or time lost. I plan to hammer home this point forever because it is that important. So many people wake up middle-aged and wonder where all the time went.
At least they’ll have several decades to course
I think you’ll have plenty of appetite for this topic over the next 2 years.
I just re-analyzed my road to FI considering moderate performance, and I should still be able to retire by 55 with no mortgage. In my book, that’s pretty good for a single income family of 3.