Ben Felix - How Much Risk Should You Take?

Short Summary

Main recommendation: Hold a globally diversified portfolio of index funds, mixing equity and bond index funds to match your ability, willingness, and need to take risk, since idiosyncratic risk is not reliably rewarded. Expected returns are highest with a 100% equity portfolio, but bonds are added to reduce volatility and fit each investor's situation.

Key Points

• Risk is what makes returns possible; avoiding risk in financial markets should be expected to produce very low returns, but risk also brings potential for loss.
• Idiosyncratic (company-specific or diversifiable) risk has no expected long-term reward, so it should be diversified away by owning the whole market rather than single stocks or sectors.
• Market risk cannot be diversified away and is the risk investors are paid for over the long term.
• Stocks have outperformed bonds globally over the past 116 years, while bonds have been less volatile; adding bonds lowers both risk and expected return.
• The amount of risk to take depends on three factors: ability (mainly time horizon and human capital), willingness (emotional tolerance for declines), and need (how much risk is required to meet goals).

Details Worth Noting

• Concrete instructions: Own a globally diversified portfolio of index funds to eliminate company-specific risk; choose the equity-to-bond mix by assessing your time horizon and human capital (ability), how large a decline you can tolerate (willingness), and how much risk your goals require (need); use less risk for short-horizon goals and more for long-horizon goals; avoid concentrating in one stock or sector.
• Example: Volkswagen's share price plummeted after its emissions scandal, illustrating idiosyncratic risk.
• Historical data cited: over 877 overlapping 15-year periods from 1928 to 2015, the US market beat risk-free T-bills 96% of the time.
• Willingness caveat: the MSCI All Country World Index fell 33% in Canadian dollars between March 2008 and February 2009; Nassim Taleb's "Lucretius problem" notes the worst historical outcome is not the worst possible outcome.
• Need example: spending $5,000 per month (inflation-adjusted at 2%) for a 30-year retirement would require about $2.5 million to fund with no risk.
• The speaker dismisses rules of thumb such as "100 minus your age in stocks" as having little basis.

Bottom Line

Risk-taking is unavoidable and necessary for returns, so the practical task is to diversify away company-specific risk and choose a stock-bond mix you can actually hold through downturns.