Personal Finance: How much risk should I take?

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Do bumps in the DOW send you into sweats, or to the trading room floor? An understanding of your risk tolerance is an important step in managing a healthy portfolio. 

Do bumps in the DOW send you into sweats, or to the trading room floor? An understanding of your risk tolerance is an important step in managing a healthy portfolio.
Assessing risk on multiple levels with every patient is one of the most distinguishing skills of an emergency physician. From diagnosis to personal liability to patient desires, we regularly gauge risk and make our decisions accordingly. But do we apply the same thought process to investment risk management? Most EPs I’ve encountered concentrate solely on investment returns and ignore investment risk. Because the level of investment risk primarily determines investment returns, we need to apply a more rational approach to determining the appropriate level of investment risk in our investment portfolios.

The dimensions of investment risk assessment

Investment risk assessment involves the evaluation of three different dimensions: the willingness to take risk, the ability to take risk, and the need to take risk. The higher your willingness, ability, and need to take risk, the higher your allocation to riskier investments such as stocks.
Willingness to take risk is purely psychological. It involves your emotional reactions to portfolio losses and market downturns. What percent loss would you be able to tolerate and still be able to sleep at night—10%, 30%, 50% or more? Would you sell in a panic or buy more because bargains abound? For the stock portion of your portfolio, you should be emotionally prepared to accept losses of 50% over a few years. From 1973-1974 and again from 2000-2002, for example, the S&P 500 (a proxy of the US stock market) lost almost 40% of its value. It’s not enough to determine your reaction to percent losses since higher portfolio values magnify emotional damage. A young physician with a $100,000 stock portfolio took a $10,000 hit in just the first 3 weeks of 2008 (the S&P 500 was down 11% in the first 3 weeks of 2008) while a physician nearing retirement with a $2 million portfolio suffered a $200,000 loss. How would you feel if your portfolio declines by an amount equal to your yearly income in a matter of weeks? While the percent loss is the same, the emotional impact of losses in absolute dollar terms is devastating at high portfolio values. Your previous investment experience and knowledge of investment history also influence your willingness to take investment risk.
Ability to take risk is a function of your age, income, and career stability. Younger physicians can take more investment risk due to their longer investment time horizon, their ability to withstand inevitable market fluctuations, and their large stream of future earned income. The 2000-2002 bear market was an opportunity for younger physician investors but a calamity for physicians nearing retirement. The S&P 500 stands at about the same level in 2008 as it did eight years earlier. EPs who work in hospitals with better payer mixes leading to higher income can also take more investment risk. Higher income and higher levels of wealth allow you to invest more money during market downturns to make up for portfolio losses. Demand for emergency services keeps growing (there were over 25% more ER visits in 2003 than a decade earlier) and so an EP’s career is somewhat shielded from the effects of an economic recession, allowing EPs to take more investment risk than other more cyclical careers. Dual incomes also allow you to take more investment risk due to higher income and lower impact from a potential disability. Similarly, a physician with adequate disability insurance can also take more investment risk.
Need to take risk is the single most important (and most often ignored) dimension of risk assessment. Your financial goals are the primary determinant of your investment risk level. Large distant goals such as retirement funding and even some short term goals such as college funding require a higher need to take risk. For example, an EP with children who want an Ivy League education instead of a public university education will need to take more risk due to the difference in funding requirements. Expenses and lifestyle are probably the largest influence on the need to take risk. EPs with low expenses, moderate lifestyles, and low personal rates of inflation don’t need high investment returns to reach their financial goals and therefore don’t need to take excessive investment risk. Finally, your portfolio value also alters your need to take risk. Higher portfolio values diminish the psychological value of the next dollar earned. For example, a $10,000 gain on a $100,000 portfolio has more financial and psychological impact than the same gain on a $1 million portfolio. So physicians who have accumulated higher levels of wealth are able to take more risk but have less need to do so. Also, any time there are larger than average investment returns your future need to take risk drops. An S&P 500 mutual fund, for example, had a cumulative return of over 80% from 2003-2007, far higher than historical averages. For most investors the recent period should have propelled them more quickly towards their financial goals, dropping their need to take risk.
Financial risk stratification involves determining your willingness, ability, and need to take risk. When these three areas conflict, your need to take risk, as determined by your financial goals, is the most important.
>>Should I risk it?  Answering this multi-faceted question can take on many forms, here are two: 
EP #1
The first is a 37-year-old adventurous single EP who loves skydiving and rock climbing. He rents an apartment and works 20 shifts per month, making an income far higher than the average EP. He started investing in 2000, just when the stock market started to tumble, but due to the past 5 years of enormous stock market gains, he has now paid off his student loans, leaving him with almost no debt.
While his willingness to take risk is high (he sky dives and invests when markets fall) and his ability to take risk is high (young, high income, low debt), his need to take risk is low so his allocation to stocks can be lower than most other physicians his age.
EP #2
The second is a 55-year-old married emergency physician with two college-aged children. He lives in a large home and has 10 more years remaining on his mortgage. The market decline from 2000-2002 scared him, and now his investments mostly consist of money market accounts and bonds.
While his willingness and ability to take risk are low (low risk tolerance, high age, high debt) his need to take risk is high (high expenses and funding needs) so his allocation to stocks should be higher than most people his age.

Setu Mazumdar, MD, practices emergency medicine in Atlanta, GA and is a member of the National Association of Personal Financial Advisors (NAPFA).

John Maginn et. al, “Managing Investment Portfolios”, from the CFA Institute Investment Series, 2007
Zvi Bodie and Paula Hogan, “For Long-Term Investors, the Focus Should be on Risk”, AAII, 2005
Larry Swedroe, “The Only Guide to a Winning Investment Strategy You’ll Ever Need”, 2005
David Cordell, “RiskPACK: How to Evaluate Risk Tolerance”, Journal of Financial Planning, 2001

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