A man walks into his doctor’s office and the doctor says, “Good afternoon, how can I help you?” The man says, “I want to get into better shape. I want to be fit and I want to start on the road towards life-long health.” The doctor says, “Fantastic! But I have to ask you an important question first. How much
illness, pain and injury are you comfortable suffering in order to meet your health goals?”
Does that sound ridiculous? Perhaps, but for years, I and countless others, have heard some variant on this question from investment advisors. Several
years ago, I sat with my family as we met with a potential money manager. He asked us how much risk we were willing to take in the portfolio. When I said
that I found this question difficult to answer, he explained that the more risk we were willing to take, the more profit we could expect, however he needed
to know how much we would be comfortable loosing. He suggested that we would be “loosing” it only temporarily if there was a down market and that it would
only be a bump on the road towards those increased profits. “So,” he asked, “could we tolerate a 20% drawdown? How about 30% or 50%?”
This type of risk tolerance inquiry has several fatal flaws. First, there is simply no way to know in advance how comfortable one is with loss. It is one
thing to say that a 30% “drawdown” is acceptable and quite another to see your portfolio actually shrink by that amount. Fear in the face of a real
downturn is what makes most people panic and sell at exactly the wrong time, lock in losses and miss the very uptrends they were hoping would save them.
There is another, more fundamental problem with framing the risk tolerance question this way. It ignores the true function of risk. People take risks in
order to achieve specific goals. In the rest of our lives we understand this relationship. We understand that world class gymnasts need to take greater
risks with their training then do casual joggers. We understand that someone battling a life threatening illness may take more risks in search of a cure,
than someone suffering from a cold. We intuitively understand that we take risks in service of achieving something and the nature and importance of the
goal dictates the severity of the risk.
This same, common sense approach should apply to the way we plan, structure and trade our portfolios. A portfolio is more than a pile of money that you
want to increase. For most people, each portfolio has a unique and important job. It is money earmarked for retirement, or college, or rent, to start a
business or perhaps, its money set aside to provide the occasional trip to Disney World. In each case, the risk that should be taken is the risk necessary
to achieve the goal. If your portfolio’s job is to provide a secure retirement for you and your spouse, and that goal can be achieved by growing the fund
by 10 percent a year, then the risk taken should only be that necessary to grow by 10 percent. The consequences of missing the mark is the lack of a secure
retirement. The upside of possibly having extra money, can’t compare with the downside of failing to achieve the goal. In other words the potential benefit
is not worth the extra risk. If you understand the portfolio’s true job, you can calculate the amount of growth you need. Assuming the goal is reasonable,
you now have a very logical, very practical assessment of how much risk you should be taking.
Of course, knowing your goal is only the first step. You also need to be able to accurately determine the path to achieving that goal. This is where
knowledgeable options traders have a real advantage. The average investor has very few tools to increase returns and hedge against risk. When a typical
financial advisor asks a family about their risk tolerance, he is really only asking about how much of the portfolio to put in equities and how much in
bonds. Perhaps he is deciding how much to put in growth stocks or how much international exposure to apply. However, his only real tools are
diversification among asset classes and the hope that history will repeat and bonds and equities will return something close to their historical averages.
Anyone who has lived through the last decade understands how tenuous that hope can sometimes be.
On the other hand, with options you can more finely tune your risk exposure and your chances of achieving your goals. That ability is a skill that takes
time and patience to develop, but it changes the game forever. With options, you can move beyond blind hope that your portfolio will increase and take an
active hand in working towards that goal. You can also more securely hedge your portfolio so you know exactly what your risk exposure is. Of course options
do involve risk. Nothing, especially returns, are guaranteed. What options provide however, is the ability to more accurately calculate and adjust how much
risk you are exposed to and how likely you are to reach your true goals. Taking risk is always going to be frightening, sometimes nerve-wracking. But
knowing that you are taking only that risk which is necessary to achieve something important should help make the process more rational and less