A reader asked for an explanation of a Risk Tolerance Curve. I am happy to oblige.
Risk tolerance can be considered in at least two ways. The first is how much risk (downward fluctuation) you personally are comfortable with. My friend Dave C has almost no tolerance for risk. His portfolio is 80% bonds and 20% stocks. He is willing to give up significant income rather than see the value of his portfolio go down, even though it would have a very low probability of default.
Another way to look at risk tolerance is how much investing time you have left to absorb pricing down turns due to business cycles. If you are 20 years old, you have 45 years left until retirement and 60 years of life left. You can wait out many business cycles, so you can take lots of risk. If you are 65 years old you can retire and you have maybe 13 years of life left. You can still wait out a recession, but might not make it through a depression. You would want to be more careful and take less risk.
To make a Risk Tolerance Curve, you would build an axis of age on one axis and volatility on the other (volatility can be translated back into an asset allocation). If you were 20 years old you might be comfortable with 25% volatility. So you would put a point on 25% above 20-years old. At age 40 you might be comfortable with 20% volatility. You would repeat the exercise for every 10 or 20 years. Joining the points would give you a Risk Tolerance Curve.
Translating volatility back to a three factor asset allocation (stock, bonds and cash) might look like this. 25% volatility is equal to 100% stocks. 12% volatility is equal to 100% bonds. 6% volatility is equal to 100% cash. You can blend the three to come up with any risk tolerance between 6% and 25%.
I hope this clarified what a Risk Tolerance Curve is.
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