The Erosion of Portfolio Loss Tolerance over Time:
Defining, Defending, and Discussing

Abstract

Using two lenses, we explore the role of time in the erosion of loss tolerance of a goal-based investment portfolio. Dubbing this phenomenon goal-based “theta risk,” we also seek to build out the importance of developing tools and techniques for defending against portfolio losses within a goal-based framework. This article reviews the theory of theta risk, explores two adapted techniques for defending the erosion of loss tolerance, then discusses some implications that are illuminated by these techniques. In conclusion, we find that (1) time erodes the loss tolerance of a goal-based portfolio in a quantifiable way, and (2) ironically, more risk (and thus return) from the outset generates more risk tolerance in the end, all else being equal.

TOPICS: Portfolio construction, risk management