How to tilt your portfolio

You need two crucial pieces of information.

#1. Minimum Rate of Return (MRR), and #2. True Risk Preference (TRP)

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Before you can choose your asset classes, you need to have a reasonable estimate of the minimum rate of return for your portfolio. Here's the formula, and we'll define the terms on the other side.

#1. MRR = (account value when distributions begin) - (account value today) / number of years until distributions begin.

For example: Today you have $100,000 in your investment portfolio, and you estimate that you will need $600,000 when your contributions end and withdrawals begin. You need to accumulate an additional $500,000. You would like to retire in 20 years, so you need $25,000 per year to get there.

You estimate that you'll contribute an average of $15,000 per year to your account, which means your investments have to provide the other $10,000 per year in growth.

At this point, you can use any of the scores of free retirement calculators out the (just Google "retirement calculators" to find one that's easy to use). The calculator will give you the average annual rate of return you'll need to hit your target of $600,000 in 20 years.

Let's say your MRR comes out at 8% per year. Now you have a basis for choosing your asset classes. There is some combination of stocks, bonds, REITs, commodities, gold, etc. that will generate the 8% with the least amount of risk to your principal. 

We'll cover this in a later lesson.

#2. True Risk Preference (TRP)

The investment advisory and planning industry spends a great deal of time talking about "risk tolerance." But what does that mean, exactly? Are they talking about financial water-boarding, where you reach the point where you just can't take it anymore? How many fingernails you are willing to have removed, financially speaking, before you cry uncle? And how do these professionals go about the task of finding your risk tolerance?

With questionnaires. Every Tom, Dick and Mary in the advice and planning business has a questionnaire for this very purpose, and most of them are useless. I go another way. I think of financial risk as a matter of personal preference rather than tolerance. What's the difference?

It's easy (and practically useless) to answer a question about your risk tolerance by saying "I can tolerate a decline of 20%." In fact, over 80% of respondents give this answer. However, when push comes to shove, and the market goes into bear mode, these 20% warriors are nowhere to be found. Most have already headed for the exits. So much for tolerance.

Risk preference, on the other hand, forces the investor to put some thought into it. They may say that they can tolerate a 20% hit to their account, but they would prefer not to. Now we're getting somewhere.

So, the next logical question is this: at what point would you begin to feel so uncomfortable that you would want to take steps to protect your nest egg from further harm? You won't find this question on a standard risk tolerance questionnaire.

Many investors who claim a tolerance for a 20% hit would become uncomfortable much sooner - 10% or 15% perhaps. Here's my point.

Your true risk preference can be found in your trading history. What did you actually do in late 2018 when the market corrected by nearly 20%? Did you stand firm? Did you delay contributions to your accounts? Did you buy more?

What did you do in 2008? or 2000-2002? This is where your true risk preference can be found.