The Libby Model of Financial Risk
All the financial books I’ve read agree that to invest successfully one should begin as early as possible, preferably in one’s 20s. And one should invest heavily when young in the riskiest asset classes, such as small-cap stocks. As one gets older, one can transition to progressively more conservative assets, like federal bonds.
There’s no doubt in my mind that one’s willingness to take financial risks should tend to decline with age. However, what the investing books I’ve read neglect is that while one’s willingness to take risks tends to decline, one’s ability to take risks tends to rise with time. A college-educated 25-year-old tends to have a higher income than a 20-year-old. And, regardless of education, a 35-year-old tends to make more than a 25-year-old.
So, in my estimation, one’s tolerance for financial risk is not a simple function of time. In the graph below, I’ve shown one’s Ability to take financial risks as a straight pinkish line, going upward over time. (This is not strictly realistic, but a reasonable first approximation.) Willingness to take financial risks probably drops faster than linear, so I’ve represented that relationship as the square of a linear drop – that is, (1 – Ability)^2. Multiplying Willingness by Ability gives one’s Tolerance for Financial Risks, which is the dark blue curve, or, what I call the Libby Model of Financial Risk Tolerance.
Admittedly, this is a very simple model. I have not accounted for having children, which should presumably dent both one’s willingness to take risks and one’s financial ability to do so. And it does not account for getting married, which probably should not have as much of an impact on risk tolerance since it generally involves uniting with someone about the same age. Nevertheless, I hope it can shed some light on what I believe one’s optimal asset allocation should be when investing.
You can see that, according to this very simple model, one’s tolerance for risk should rise sharply in one’s 20s (because one’s income should be rising dramatically, even though one’s willingness to take risks is dropping). This is perhaps part of the reason why one’s 20s are often so exhilarating. I remember getting my first paycheck and seeing that my checking account had a 4-digit balance. I hadn’t seen a comma in a dollar figure since before I started college.
Contrary to the advice of most financial planners, this very simple model implies that one’s 20s are NOT the time for maximizing financial risks. Instead, perhaps the 30s and early 40s are the time for putting one’s biggest chips on the table.
Perhaps this simple relationship also partially explains the mid-life crisis many men experience in their 40s and 50s, as one acknowledges one’s tolerance for risk declining even as one’s financial ability to take risks increases into the ‘peak earning years’.
And, maybe it helps to explain the sense of completeness people tend to feel in their 60’s and beyond, when they recognize their financial situation reaching its peak, their tolerance for risk coasting slowly back down and decide to devote more time to enjoying life than worrying about starting a business or a new career.