risk
Capacity, willingness, need
The rule
Take the smallest of three: the risk you can afford, the risk you can stomach, and the risk you actually need to reach your goal.
Where it flips
Your stomach can be trained. Your room to lose and your need are harder to change. Over a career, building the calm to hold through falls slowly raises the level you can safely run.
Swedroe's rule stops two opposite mistakes. Someone with a big appetite but little room to lose (a big loan, an unsteady income) should not run a risky portfolio just because losses do not scare them. A shock will force a sale. Someone with plenty of room but a weak stomach will panic-sell in a fall anyway. And someone who already has enough does not need much risk at all. The right level is the smallest of the three, not the biggest.
A worked example
A 28-year-old has a steady job, so plenty of room to take risk. But he panicked and sold in the last crash, so his stomach is weak. He should hold less in shares than his age suggests. His stomach is the limit. [illustrative]
How to spot it
- ·all three checked, not just appetite
- ·the lowest of the three chosen
- ·room to lose checked against steady income and debt
Larry Swedroe · Rational Investing in Irrational Times; Bernstein