Every investment carries risk. Even a total stock market index fund. That’s why there is a lot of talk about determining your risk tolerance in investing. My problem with figuring out your “risk tolerance” is that it is an abstract concept. So instead, I like to think of it in terms of figuring out your “investing margin for error.”
Let’s start with risk tolerance…
This is obviously a matter of semantics. However I think semantics can be important.
So, when we talk about risk tolerance, we are talking about how much risk we are willing to accept with our investments. Because the general rule of thumb is that increased risk is correlated/rewarded with increased investment returns.
But this is where the problem comes in. The semantics of risk tolerance seem to ask you to perform your self-assessment in a vacuum. How much risk are you willing to accept? That question exists outside of the reality of your personal finances.
Through this blog and just talking with people about personal finance, I have seen these semantics lead to some bad self-assessments.
Some doctors with no savings and investments tell me their risk tolerance is very high. Meanwhile, others who already have reached financial freedom with room to spare tell me their risk tolerance is very low. However, I’m not always sure that these are accurate assessments.
And I’m pretty sure that the thought experiment they internally ran to arrive at this assessment was faulty. But why?
This is where your investing margin of error come into play
Let me lay out what I think is a much more helpful thought experiment.
How much margin of error do I have for my investing strategy? I.e. How much could I stand for my investing strategy to be wrong and still reach my financial goals?
To me, this is a much more practical and useful way to determine the risk that you are willing to accept in your investments.
Why investing margin of error is better than risk tolerance
The formula to build wealth is simple:
- Create and increase the margin between what you make and what you spend
- Invest that margin
General rules of thumb that follow are for physicians to create a margin of at least 20% of gross income and to invest in low cost, broadly diversified index funds.
However, whiles these may be the general guidelines to build wealth, we all need a goal. And this goal is our nest egg. And our nest egg is equal to the amount of investments and/or passive income that we need to sustain ourselves without working. Therefore, when you reach your nest egg, you are finically free – living life on your own terms.
Each of our nest egg goals will be different (here is a useful guide to determine your own goal nest egg). And this simple truism is important to understand.
Because your investing margin for error depends largely on two main factors
And these two main factors are:
- What your goal nest egg is and
- Where you are in the journey to reach that nest egg goal
And these play out in terms of your investing margin for like this:
- The higher your goal required nest egg, the less margin for error
- The lower your goal nest egg, the higher margin for error
- The further away from your nest egg that you are, the less margin for error
- The closer to your nest egg that you are, the greater margin for error
Where do I fall in this equation?
Let’s take me for example.
My nest egg/passive income goals are here.
My goal required nest egg is (I would say) high. And we are still relatively far from the goal despite generating ~$10k/month from cash flowing real estate.
Thus, our margin for error in our investing strategy is on the lower end of the spectrum. If our investing plan doesn’t work (at all or as well as we estimate), we are in trouble.
That’s why we created a written financial plan that looks like this. The bedrock of our investing plan is via low cost, broadly diversified index funds of stocks and bonds along with cash-flowing real estate using our set analysis criteria.
This investing strategy is not without risk. But it has a low margin of error. And that is what’s important. Enough to get us to our goals, not enough to derail us.
That is why we don’t invest in some tempting but more risky investments like these. Sure, they may pan out, but the margin of error is too great. If it doesn’t work we may not reach out goals.
And I’d rather be called a boring investor who reached their goals.
Let’s examine some extremes now
So, that’s my situation. But not everyone is in my situation.
Let’s say that you’ve already reached your goal nest egg. And you are still earning an income because you are working on your own terms. And let’s say you save some of that income. You don’t need it to add to your nest egg necessarily – you’ve already reached it. But you still decide to invest it.
In this case, your margin for error is quite high. You could totally swing and miss and you would still meet all of your financial goals.
Conversely, let’s take the example of the early career physician who has saved $600,000 in their savings account because their risk tolerance is low (true story).
Counter to what you may initially think, this is another example of having am margin for error that is way too high. The risk may be low, but the margin for error is super high. Because unless this doctor has a very, very low nest egg, they are unlikely to reach it through saving alone. Unless they change their investing plan, their margin of error is thus elevated.
So, like I said above, it’s about balance. Balancing your goals, your progress towards those goals, and your plan to get there.
That’s what makes this a more practical thought experiment in my mind!
Where does your investing margin for error live?
That is the important question to ask yourself. Is your margin of error acceptable to get you where you want to be? Or too high that your investing strategy is really a big boom or bust?
I consider these two posts to be required reading as you assess your investing margin for error!
You can also watch my Masterclass Webinar on The 12 Steps to Financial Freedom for Physicians here!
What do you think? Am I nitpicking semantics? Or is investing margin for error a better construct than risk tolerance? Let me know in the comments below!