If you’re looking how to quantify risk tolerance and how to determine the appropriate exposure to stocks, you’ve come to the right place. Financial SEER is a way to quantify your risk tolerance so you can try to make investment returns in a risk-appropriate manner. SEER stands for Samurai Equity Exposure Rule.
This post is also for someone who is wondering:
- Whether they have the proper asset allocation
- If there is a way to reduce investment stress while still benefitting from returns
- How to quantify their risk tolerance
- How to continue moving forward on their path to financial freedom despite all the uncertainty
- Whether the stock market is in a big bubble
Greed And Fear Control When Investing
One of my primary goals on Financial Samurai is to help readers build meaningful wealth in a risk-appropriate manner. You need to learn how to quantify risk tolerance before making the right amount of investments. Financial SEER serves to quantify your risk exposure by calculating how many months you are willing to work to make up for a potential investment loss.
With the constant push and pull between fear and greed, finding a way to quantify your risk tolerance is important. You don’t want to let your emotions take over when investing. This is what we call investing FOMO and real estate FOMO.
Instead, you must find a way to invest based on your risk tolerance and stay the course over the long term. Otherwise, you may lose lots of money, which ultimately means you lose lots of time. And time is your most precious asset of all!
Control Your Risk Exposure With Financial SEER
I started my career soon after the 1997 Asian Financial Crisis. Back then, many international college students in the US had to drop out due to a sudden and massive devaluation of their respective home country’s currencies. It was a black swan event that disrupted millions of lives, just like the pandemic today. I fully appreciate how hazardous the road to building great wealth can be.
Even the best-made plans can be laid to waste due to some unforeseen exogenous variable. We always hope for good surprises along the way. The coronavirus pandemic is certainly one of the biggest unforeseen black swan events in our lifetime. Now there’s another bear market in 2022 with the Fed hiking rates and inflation at 40-year highs.
Unfortunately, life always has a way of kicking us in the face after knocking us in the teeth. Let’s always be thankful for what we have and demonstrate kindness to those who are experiencing difficult times.
Most investors overestimate their risk tolerance, especially investors who’ve only been investing with significant capital since 2009. Once the losses start piling up, it’s not only the melancholy of losing money that starts getting to you, it’s the growing fear that your job might also be at risk.
The Richer You Are, The Harder You May Fall
You might also erroneously think that the richer you get, the higher your risk tolerance. After all, the more money you have, the bigger your financial buffer. This is a fallacy because the more money you have, the larger your potential loss. For most rational people, their lifestyles don’t inflate commensurately with their wealth.
This is why even rich people can’t resist a free rubber chicken lunch.
Further, there will come a time when your investment returns have a larger impact on your net worth than your earnings. As a result, the richer you are, the more dismayed you will be to lose money.
Your main hope for recovery is a rebound in investment performance because your work earnings won’t contribute much at all.
If you’ve been able to amass a large enough amount of capital to never have to work again, you should focus more on capital preservation instead of maximum returns.
You don’t need to be a great investor to get rich. You just need to be a good-enough investor. A good investor is able to make risk-appropriate investments to avoid blowups. Over the long run, a good investor will likely accumulate a lot more money than they need.
How Most Of Us Rescue Our Bad Investments
The reason we all continue to fight in this difficult world is because we have hope. But eventually, our hope fades because our brains and bodies slow down. When we’re younger, we often think ourselves to be invincible. Then, eventually, we start experiencing the realities of aging.
It is due to our fading abilities that we must bring down our risk exposure as we age.
It is only the rare bird that goes all-in after making enough money to last a lifetime to try and make so much more. Sometimes they turn into billionaires like Elon Musk. But most of the time they end up going broke and filled with regret.
The only way most of us can rescue our investments after a market swoon is through contributions from earned income i.e. our salaries. We tell ourselves that when the markets are down, that’s alright because we’ll simply invest more at lower prices.
However, lower prices don’t necessarily mean better value if estimates are cut, but all other things being equal, we like to trick ourselves into believing we’re getting a better deal all the same.
History Of Bear Market Declines
To understand reward, we must first understand risk. Since 1929, the median bear market price decline is 33.51%, while the average bear market price decline is 35.43% since 1929.
Therefore, it’s reasonable to assume that the next bear market could also bring equity valuations down by 35% over an 8 – 10 month period. Heck, in March 2020 alone, the S&P 500 declined by 32%.
If you didn’t have the appropriate risk exposure, you were really sweating bullets, especially you were looking to retire in 2020. Luckily, the bull market resumed soon after the big correction.
Let me share a quantifiable way to measure how much equity exposure you should have based on your risk tolerance.
I’m calling it the Financial Samurai Equity Exposure Rule or Financial SEER. It’s an appropriate acronym because seer means a person who is supposed to be able, through supernatural insight, to see what the future holds.
How To Quantify Risk Tolerance Using Financial SEER
Most people just regularly invest in stocks over time through dollar cost averaging. They have little concept of whether the amount of stocks they have as part of their portfolio or their net worth is risk appropriate.
Hence, to quantify your risk tolerance based on your existing portfolio, use the following formula:
(Public Equity Exposure X 35%) / Monthly Gross Income.
For example, let’s say you have $500,000 in equities and make $10,000 a month. To quantify your risk tolerance, the formula is: $500,000 X 35% = $175,000 / $10,000 = 17.5.
This formula tells you that you will need to work an 17.5 ADDITIONAL months of your life to earn a GROSS income equal to how much you lost in a -35% bear market. After taxes, you’re really only making around $8,000 a month, so you will actually have to work closer to 22 more months and contribute 100% of your after-tax income to be whole.
But it gets worse. Given you need to pay for basic living expenses, you need to work even longer than 22 months. Good thing stocks tend to rebound after an average bear market duration of 10 months, if you can hold on.
Given everybody has a different tax rate, I’ve simplified the formula using a gross monthly income figure instead of a net monthly income figure. Feel free to adjust the Risk Tolerance Multiple based on your personal income tax situation.
Quantifying Your Risk Tolerance Asks How Much You Value Your Time
Quantifying risk tolerance by calculating working months is the best way to go because time is money. The more you value your time, the more you hate your job, and the less you desire to work, the lower your risk tolerance.
The classic scenario is a 68-year-old retiree with a $1,000,000 portfolio living off $20,000 a year in Social Security and $20,000 in dividend income from his portfolio.
If his portfolio loses 30% of its value because it is way overweight equities, it is almost impossible to recover the lost $300,000 on his $20,000 a year fixed income. His dividend income may likely be cut as well as companies hold onto their cash for survival. The only thing this retiree can do is pray the market eventually goes up while cutting spending.
In 2022, I had a softball friend lose 17 years worth of savings because he bought Tesla stock on margin. He went all-in as a early education teacher. To recover his paper losses, he has to work 10 more years. Please don’t buy stocks on margin.
How To Determine Appropriate Equity Exposure
After you have quantified your risk tolerance by assigning a Risk Tolerance Multiple = the number of months you need to work to make up for your potential bear market loss, take a look at this guide below.
My guide gives you an idea of what your Risk Tolerance Multiple is. It also gives you an idea of what your maximum equity exposure should be based on your risk tolerance. Solutions!
Don’t risk more than 18 months worth of gross salary on your equity investments. This assumes a 35% average bear market decline in your public investment portfolio.
In other words, if you make $10,000 a month, the most you should risk is a $180,000 loss on a $514,285 pure equity portfolio. Follow the risk exposure formula as you make more money.
The Max Equity Exposure formula = (Your Monthly Salary X 18) / 35%.
You can certainly have a larger overall public investment portfolio than $514,285 in this example, but I wouldn’t risk much more than $514,285 in equities only if you have only a $10,000 a month gross salary.
You can have $514,285 max in equities plus $250,000 in AAA-rated municipal bonds if you wish, for a reasonable 67%/33% equities fixed income split. Your total portfolio size would therefore be $764,285.
Adjust The Assumptions As You See Fit To Measure Risk Tolerance
If you think the next bear market will only decline by 25%, feel free to use 25% in the Max Equity Exposure formula. In the above example, the result would be ($10,000 X 18) / 25% = $720,000 of maximum equity exposure for someone making $120,000 a year.
If you just got promoted and plan to see 20% YoY earnings growth for the next five years, you could use your current monthly salary and a higher Risk Tolerance Multiple to determine your equity exposure.
For example, let’s say you currently make $10,000 a month, but expect to make $20,000 a month in five years, You also think stocks will go down by 25% at most. The calculation would therefore be: ($10,000 X 36) / 25% = $1,440,000 as your target or maximum equity exposure.
If you decide to live like a hermit in a low cost town in the middle of nowhere, you could increase your Risk Tolerance Multiple to 36. But you’ve got to question your money priorities for trying to make a bigger return only to never spend your rewards.
Add A Risk Tolerance Multiple Buffer
Remember, whatever your Risk Tolerance Multiple is, you will have to increase it by 1.2 – 3X to truly calculate how many more years you will need to work to recover from your bear market losses due to taxes and general living expenses.
It is a judgment call regarding how much equity risk you should take. If you’ve quadrupled your net worth after a 9-year bull market, it’s probably wise to lower your risk exposure multiple. Conversely, after a 30%+ correction in equities, it’s probably wise to increase your risk exposure multiple.
The closer you get to retirement, the lower your multiple should be as well. Nobody wants to get close to the financially free finish line only to break a leg. The ambulance ride will be the most depressing ride ever!
Be A Rational Investor With Financial SEER
The valuation of everything is dependent on current and future earnings. It takes time and energy to create those earnings from your job or your business. If you are seriously burning out, please dial down risk and give yourself some time to heal.
For the average person in a normal economic cycle, a gross Risk Tolerance Multiple of 18 is my recommendation. Most people have the fortitude to waste up to around 2-3 years of their lives to gain back what they’ve lost from a bear market. But after three years of digging out of a hole, things start to feel hopeless. The average person starts giving up.
Remember, things could always be worse! Not only could your stock investments lose more than 35%, you could lose all your home equity due to leverage, your business, your job, and your spouse as well. Please invest rationally and responsibly.
I hope the Financial Samurai Equity Exposure Rule (SEER) helps you take the subjective term of risk tolerance and shapes it into something quantifiable. You now have a concrete way of determining your equity exposure and risk tolerance.
Financial SEER Formulas To Quantify Risk Tolerance:
Risk Tolerance = (Public Equity Exposure X Expected Percentage Decline) / Monthly Gross Income
Maximum Equity Exposure = (Your Monthly Salary X Risk Tolerance Multiple) / Expected Percentage Decline
The key point of Financial SEER is to help you quantify your risk tolerance by measuring how much TIME you will lose or are willing to spend to make up for your loses.
Wealth Building Recommendations
1) Quantify risk tolerance by tracking your finances like a hawk.
The more you can stay on top of your finances, the better you will optimize your finances. To do so, sign up for Personal Capital, the web’s #1 free wealth management tool to get a better handle on your finances.
After you link all your accounts, use their Retirement Planning calculator. It pulls your real data to give you as pure an estimation of your financial future as possible. Definitely run your numbers to see how you’re doing.
2) Invest in real estate for steadier returns and lower volatility
Diversifying into real estate is a great way to dampen investment portfolio volatility. Unlike stocks, real estate values provide utility and don’t just plummet in value overnight.
Check out Fundrise and CrowdStreet, two of my favorite real estate crowdfunding platforms. Fundrise offers diversified funds while CrowdStreet mainly offers individual real estate deals. They are free to sign up and explore.
In 2017, I reinvested $550,000 of my proceeds from a SF rental home sale into 18 commercial real estate properties. It’s great to earn income passively and diversify away from my expensive San Francisco real estate holdings. Investing in heartland real estate is a long-term trend I don’t want to miss.
Financial SEER And Quantifying Risk Tolerance is a FS original post.
A few things I’m trying to understand here.
1) How should margin play into your equity allocation / SEER formula?
2) When you say equity allocation, are you talking about liquid assets only?
3) This ratio tends to imply massive equity portfolios for high earners ($810k annual gross cash comp) even though a large amount of that gets eaten up by taxes. What is the appropriate adjustment?
Olaf, the Mile High Finance Guy says
Interesting concept. Currently I would be at a ~33, which I am fine with, as I am not depleting my investments and I love my work life balance. After I reached FI, I quit my day job and continued my consulting work, which I love. I also was offered a part-time job working at a small RIA, which I hadn’t banked on. So, in total, I work 20-25 hours a week, which is doing things I love when I see fit. I do realize though that my situation is very fortunate and that not everyone has this luxury. I also tend to be a high risk personality and have long believed in a high equity portfolio hedged with REITs. It also doesn’t hurt that my spouse loves working and has no plans to stop, either. I appreciate the formula, as it quantifies losses in a way I hadn’t thought. Keep up the great work, Sam!
I must be miss-understanding something. Let’s say you have a $5M portfolio, have a 60%/40% stock/bond allocation and make $200k/yr. This makes your equity exposure $3M, which is far higher than your top row in your SEER table (which I calculate to be a little more than $1.7M max equity exposure when extrapolating from your table). Typical investment advisors say a 60/40 split of stocks and bonds is a very sound allocation. This doesn’t jive with being even higher than your top level “Extreme” risk taker category.