Risk tolerance and relative risk aversion (RRA) are the same thing, just expressed in different ways. A risk tolerance of 12 corresponds to an RRA of 3.05, 13 corresponds to 2.62, etc.Hey Ben,
Conservative: Risk tolerance = 7 (RRA = 6.48)
Moderate: Risk tolerance = 12 (RRA = 3.05)
Aggressive: Risk tolerance = 17 (RRA = 1.44)
A few quick questions. I've been using the tool for a while and have posted a few times.
1) Is there a tool to try and gauge Risk Tolerance?
2) Is there a tool to try and gauge RRA?
3) If TPAW is using RRA under the hood, why use Risk Tolerance for the input?
thanks
We converted RRA to risk tolerance and used that on the slider because it leads to a more intuitive slider. The left side of a risk spectrum is usually conservative and the right side aggressive. If we put RRA directly on the slider, that would become inverted: left would be low RRA and aggressive, and right would be high RRA and conservative, which would be confusing. When converting RRA to risk tolerance, we also use a log scale because the difference between an RRA of 1 and 2 is greater than the difference between an RRA of 5 and 6. The log scale spreads it out better for the slider.
The best way to gauge your risk tolerance/RRA is by simply adjusting the risk tolerance slider till you arrive at the spending graph (and legacy outcomes) that you most prefer. There are tools like surveys and thought experiments to help you evaluate your RRA, but those are less reliable because you are not making the evaluation in the context of real world financial circumstances. They are based on artificial scenarios that may not translate well enough to your actual circumstance and don't provide the full context of the choices that you are facing. This is especially a problem if you have created a spending floor (by adding essential extra expenses). Your risk aversion should be evaluated in the context of that floor. If you have a floor that covers your essential expenses, you can take more risk on the risk portfolio. That would mean entering a lower RRA (higher risk tolerance) on the slider. A survey can miss this if you're not careful to account for the floor when answering questions. But the planner will catch it. Evaluating your risk tolerance inside the planner by adjusting the risk tolerance slider will avoid these types of errors.
RRA simply measures how willing you are to take on risk. That risk is displayed in the spending graph. You don't need anything more. If you get an RRA from a survey, that is simply a guess about how you would adjust the risk slider when faced with these choices. You don't need that guess—you can just adjust the slider and find it directly!
If you still want to get an RRA estimate from outside the planner, the Missing Billionaires survey (pages 175-180) and Professor Campbell's demon thought experiment that ConstantChrysalis referred to above are good sources. But make sure that you don't blindly enter the results in the planner. Instead, look at the spending graph in the planner and adjust the risk aversion slider till you find the spending distribution that you most prefer. If the RRA you get from the planner is different from the survey and thought experiment results, go with the RRA you found through the planner. It's effectively a richer survey administered in the perfect context—the financial choices that you actually face in real life.
Note also that this approach of adjusting the inputs based on the outcomes shown in the spending graph is how the planner is meant to be used for all inputs, not just for risk tolerance. For example, the choices of how much to save, when to retire, etc, should be made based on how it’s affecting the spending graph. The spending graph is what captures the material impact of all of those decisions on retirement. This is why it's the default view of the planner and why we have taken care to make the graph visible when you enter any of the inputs. It always boils down to what's happening in the spending graph.
Statistics: Posted by Ben Mathew — Tue Sep 24, 2024 5:58 pm — Replies 1024 — Views 282332