The losses we saw in the stock market in 2008 as measured by the Standard & Poor’s 500 index1
surpassed previous annual losses since 1825 with the exception of 1931, reports Value Square Asset Management and Yale University. Last year’s losses weren’t confined to stocks, since corporate bonds lost value as well. Recently a money manager told us that in October, if you wanted to sell a bond position, it was difficult to find a buyer at any price. If you were invested during the last quarter of 2008, there was no place to hide — except in cash or U.S. Treasury securities.
The whole issue of risk is a difficult one to discuss. Unlike measuring height or weight, there’s no unit of measurement for risk tolerance. Your risk tolerance can be measured only relative to others on a constructed scale in much the same way an IQ is measured. Even the meaning of the word risk can depend on the situation. When individuals talk about risk as they experience it in their financial affairs, they aren’t talking about the same thing as investment researchers discussing the risk of a particular kind of investment.
As we mentioned in our November 2008 article, we provide our clients with a risk tolerance questionnaire with 20 questions. But this only gives us an idea of what degree of risk people are willing to take at the time they’re completing the questionnaire.
We have to recognize that your risk tolerance changes and can be easily influenced by recent information and even your moods. It’s easy to rate yourself as an aggressive risk-taker when you think home values and stock prices can only go up. When they come crashing down again, though, people tend to become very conservative very fast.
We think there are two basic ways of looking at risk-taking. The first is to assess the amount of financial risk you can afford to take. The second is to assess the amount of emotional risk you’re willing to take.
When assessing the level of financial risk you can afford to take, consider your age as well as the amount of assets you have. For instance, if you’re relatively young and part of a two-earner couple who don’t spend all your income, you should be able to afford to take more risk with your investments because you have time on your side. Even if your investments don’t work out as you hoped, you can make other investments in the future.
Those who are retired and need to live on the income from their investments, however, can’t afford to take as much risk. With retirees living longer than they did in previous generations, this has become more of an issue, particularly for those who don’t have a pension providing them with regular income.
The size of your total assets influences your attitude toward risk as well. People who have more assets than needed to maintain their lifestyle usually are willing to take more risk with at least some of their investments.
During the tech debacle of 2000-2002, values of homes were increasing. Assuming you hadn’t invested all your portfolio in tech stocks, even though the stock market was down as measured by the major indexes, you didn’t feel as poor because your house was worth more. Thus, you could tolerate riding out the down market of 2000-2002.
Between 2003 and 2007, your patience was rewarded, and hopefully you saw your investments grow in value. At the same time, the value of your home continued to go up. In some cases, during this period some retirees became complacent and withdrew more than the recommended 5 percent from their portfolios because they could do so. After all, they reassured themselves that their principal was intact. This past year’s market decline has changed all that. Now investors realize that markets really do go down as well as up and their investments can decline in value.
Once you’ve figured out how much financial risk you can afford to take, you need to measure your emotional attitude toward risk-taking. If your parents or grandparents lost all their money in 1929, or if your father wasn’t good at managing money, you may have difficulty taking risk with your own money. This is a very human reaction. It’s important to realize that these negative family experiences can have a lasting negative effect on your attitudes.
In addition, your attitude toward taking risk can vary over time based on your most recent experiences (either positive or negative) when you took risks. For example, some new clients will say they’re highly risk-averse, but when we examine their portfolios, they own some speculative investments. When we ask about this apparent inconsistency, they usually reply that they used to be risk-takers, but these investments didn’t work out well, so now they’re less willing to take risk. Obviously, the reverse can be true. If your experiences with taking risks were rewarded in the past, you’ll probably be more willing to take chances in the future.
After you’ve assessed how much risk you can afford to take and how much risk you’re comfortable taking, you should focus on risk reduction techniques. It’s important to start with the basic premise that it’s virtually impossible to avoid risk altogether. For instance, when you cross the street, you run the risk of being hit by a car. But there are ways you can reduce your risk. If you cross the street at a marked intersection when the light clearly indicates it’s safe for you to walk, you’ve greatly lessened your risk of being hit. If instead you’re jaywalking, you’re taking more risk.
When investing, the first way to control the negative impact of risk-taking to some extent is by doing your homework. There’s a difference between taking educated risks and speculating. Speculating is equivalent to racetrack betting if you put all your money on one horse with the name you like or the color of silks you prefer.
As a BetterInvesting member, you’re familiar with this concept of educating yourself. A company might have a wonderful product, but you need to check out its competition, the amount of debt the company has, its record of earnings and the relationship of earnings to the stock’s current price before deciding to invest in it.
We believe you can also reduce the risk you take with investments by diversifying2
your portfolio among different kinds of investments (international/U.S. stocks, bonds, cash) and within asset categories (small-cap, large-cap and so on). If you diversify, one investment might not work out as well as expected, but others may do well so that overall your total portfolio is worth more than the amount you invested.
For example, let’s compare two investors. Mary invests $100,000 that earns 8 percent annually. At the end of 20 years, her portfolio is worth $466,096. On the other hand, Jane invests her $100,000 among five different investments — $20,000 each. After 20 years she assesses her situation. The first investment is a total loss, while she gets her money back with the second. With the third investment, she received an average annual return of 5 percent; the fourth, 10 percent; and the fifth, 15 percent. At the end of 20 years, she would have $534,947 — almost $100,000 more than Mary does (see table, below
Another way you can control your risk is to work with an experienced financial adviser. Although this isn’t necessarily a panacea, the adviser can show you different investment alternatives and explain both the risk and return potential of each choice. That way you can construct a portfolio that matches your risk tolerance.
We explain to clients that there’s no right or wrong attitude toward risk. What’s important is that you’re honest with both yourself and your adviser about your risk tolerance and construct your investment portfolio accordingly.
Rank your own risk temperament on a scale of 1 (risk-averse) to 10 (willing to take a high degree of risk) and then make sure you communicate this information to your adviser. If you’re married, are you more or less of a risk-taker than your spouse? We’ve often seen instances in which one spouse is willing to take a lot of risk and the other is willing to take few risks. This can lead to family conflict. You need to discuss this issue with each other, and some compromises may have to be made. For instance, the spouse who’s more willing to take risk might invest part of her portfolio in more aggressive investments than her partner.
After experiencing the 2008 stock market, many investors are shellshocked and may vow to avoid investing altogether, thus trying to avoid taking any risk. We don’t think this is a wise decision. Although this past year’s experience has been very difficult for everyone, it may have some good long-term results. Perhaps people will realize that you can’t make fortunes overnight, that you should avoid being heavily in debt, that you shouldn’t spend all your income, that it’s important to accumulate a cash reserve for a rainy day and that you really need to investigate before you invest. In other words, they may start believing all those maxims that financial planners have been preaching for years!
Although taking some risk is essential to making money, it has been our experience that you don’t have to be a speculator to build wealth successfully. We advocate controlling the amount of risk you take through self-education, portfolio diversification and consultation with a good adviser.
Having been in the investment business for over 40 years, we really believe that ultimately the pendulum will turn and selecting and holding good-quality investments will reward patient investors. We encourage you to take a deep breath, take educated risks and make sound decisions that aren’t based on emotions.
Keep in mind the tortoise and hare race. We believe the slow, steady, consistent approach works every time. 1
The S&P 500 index is an unmanaged index comprising widely held securities considered to be representative of the stock market in general. Performances of the indexes are not indicative of any particular investment. Individuals cannot invest directly in any index. Past performance is no guarantee of future results.2
Diversification doesn’t guarantee against loss. It’s a method used to manage risk.