The Financial Samurai Equity Exposure Rule, or SEER, is a financial equation that determines how much an individual should have in stocks based on his or her income and risk tolerance.
Risk tolerance has always been hard to quantify until today. Financial Samurai determines risk tolerance by how many months an individual is willing to work to make up for potential losses in his or her portfolio.
The average bear market since 1929 has shown a 35% decline. The median decline is roughly 33%. The average bear market lasts between 8 – 10 months. Therefore, one can determine calculate how many months a person has to work to make up for potential 35% loss.
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.
Financial SEER Rule
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 save 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.
The formula to quantify your risk tolerance is: (Public Equity Exposure X 35%) / Monthly Gross Income.
For example, let’s say you have a $500,000 public investment portfolio and make $10,000 a month. To quantify your risk tolerance, the formula is: $500,000 X 35% = $175,000 / $10,000 = 17.5. 35% is the average bear market decline in history.
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 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 a bear market over the long run, 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. But the real amount of months it takes to make up a loss can easily be 1.5X – 3X the Risk Tolerance Multiple due to taxes and living expenses.
Quantify 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.
Determining 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 will not only give you an idea of what your Risk Tolerance Multiple is, but it will also give you an idea of what your maximum equity exposure should be based on your risk tolerance.
My advice to all investors is to not risk more than 18 months worth of gross salary on your equity investments using an assumed 35% average bear market decline in your public investment portfolio.
The Max Equity Exposure formula = (Your Monthly Salary X 18) / 35%.
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.T
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.
Make Personal Adjustments
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 could calculate: ($10,000 X 36) / 35% = $1,026,571 as your target or maximum equity exposure.
If you decide to live like a beggar 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.
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.
Be Realistic With Your Risk Tolerance
The average person should stick with a Risk Tolerance Multiple of 18. Most people have the fortitude to waste up to around 24 months (net of taxes and living expenses) of their lives to gain back what they’ve lost from a bear market. But after 24 months of digging out of a hole, things start to feel hopeless as the average person starts giving up.
The closer you are to retirement, the more you hate your job, the less multiple income streams you have, and the less you want to work, the lower your Risk Tolerance Multiple should be.
Remember, the value of anything is based off a multiple of current and future earnings. If you see a huge decline in your future earnings, your wealth is at risk of decline. But that’s OK, since life is finite. We need to figure out how to best spend our money and not die with too much.
Use the Financial Samurai Equity Exposure Rule (SEER) to help you determine your appropriate equity exposure in your portfolio. Long term, equities move up and to the right. But you must be able to have the property risk allocation to be able to hold long term to make your fortune.
Financial SEER formulas:
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
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