When Matt Keeling, a certified financial planner from Mashpee, Mass., talks about risk, he likes to share a bit of family lore. After making some money in the stock market several decades ago, Keeling’s grandfather wrote a letter to his tax adviser asking him to help him find an investment with a high yield, no risk and no tax implications.
The tax adviser’s response? “I’m a C.P.A., not G.O.D.”
In case last year’s market mayhem didn’t make this painfully clear, there is no such thing as a risk-free investment. Even in the best of economic times, risk and reward go hand in hand. If you avoid risk, you’ll need to accept lower returns. If you embrace risk, you stand to gain more – but you also stand to lose more. “Investing is always about tradeoffs,” says Keeling.
Loss of principal might keep you up at night, but inflation and interest rate risk will chip away over time.”
MATT KEELING, CERTIFIED FINANCIAL PLANNER
The trick is finding a balance between risk and reward that you can live with – financially and emotionally.
Trouble is, most investors aren’t very good at gauging their ability to take on risk, says Meir Statman, a professor of behavioral finance at Santa Clara University. “In good times, when people say they can take risk, what they’re often saying is they think the market will go up, says Statman. “When the market goes down, that exuberance is quickly replaced with fear.”
Fear can be as dangerous as exuberance if it causes you to invest too conservatively. “You’re trading one risk for the other,” says Keeling. “Loss of principal might keep you up at night, but inflation and interest rate risk will chip away over time.”
Striking the right balance
How do you find a balance? Experts say it’s important to distinguish between your capacity for risk, which is based on such factors as your age, investment time horizon and overall financial situation, and your appetite for risk, which is purely psychological. Your capacity for risk is by far the most important factor, says Statman. “I might be 82 and have a huge appetite for risk, but that’s irrelevant if I’m living on Social Security and can’t afford to ride out the market,” he says.
When thinking about your capacity to take on risk, the first question to ask yourself is when will you will need the money, says Robert Laura, an adviser with Synergos Financial Group in Howell, Michigan.
In general, the longer your time horizon, the more risk you can afford to take, but that doesn’t hold true if you don’t have your financial house in order. Last year many investors learned this the hard way when they were hit with the double whammy of job losses and portfolio losses. “Part of assessing risk is making sure you can afford to invest in the stock market in the first place,” says Keeling. “If you’re investment account and emergency account are one in the same, it won’t work.”
Assuming you have cash reserves set aside, a good rule of thumb is to subtract your age from 100 for a rough idea of what percent of your portfolio should be in stocks. In genreal,a 40-year-old investor would keep 60% of her portfolio in stocks. For a more detailed look at what asset allocation makes sense for you, Fidelity’s portfolio review tool will give you a target asset mix based on your age and the and your financial goal. Similar tools can be found on Bankrate.com, CNNMoney.com and SmartMoney.com.
Your appetite for risk
Risk-profile questionnaires are one way to gauge your appetite for risk. FinaMetrica’s 25-question risk-tolerance test ($30 at myrisktolerance.com) is considered one of the most accurate measures of psychological risk tolerance. If your score suggests that you have a low tolerance for risk, that may be an indication that you should reduce the percentage of stocks in your portfolio. Just don’t swing too far to the conservative side, says Synergos’ Laura, or you risk not earning enough of a return to reach your goals. “It’s a double-edge sword,” he says.
If your score renders you prime for risk taking, however, don’t assume you can allocate 100% of your portfolio in high risk emerging-market stocks. Unless your capacity for risk matches that appetite, you probably don’t want to exceed the model allocation. “Remember that this questionnaire is measuring your confidence, not your capacity for risk,” says Meir. “You need to make that distinction.”
Of course, scoring your risk tolerance does you no good if you truly don’t know how risky an investment is. Many investors got burned last year not because they overestimated their tolerance for risk but because they underestimated the risk in their portfolio. When thinking about risk, it helps to put things in dollar terms. Fidelity’s portfolio review tool shows the highest and lowest returns for different asset mixes over one-year and 30-year periods. Translate those percentages to dollars, says Joni Clark, chief chief investment strategist for Loring Ward investment advisory. Then ask yourself whether you could stomach the worst-case scenario.
Diversification is key
Monitoring portfolio risk also means making sure you’re truly diversified. “There’s a big difference between putting 70% of your portfolio in one stock and 70% in a diversified mix of stocks,” says Chris McDermott, senior vice president of investor education and financial planning from Fidelity Investments.
Likewise more isn’t necessarily better when it comes to building a portfolio of mutual funds. “What we typically find is people think they have a diversified portfolio when they actually have four of the same funds,” says Laura. “You want to make sure your funds don’t overlap.” Fidelity’s portfolio analysis tool gives existing Fidelity customers a comprehensive look at the holdings in your portfolio either by individual account, such as your 401(k) or IRA, or in the aggregate. SmartMoney.com also has a portfolio tracker tool.
Once you’ve mapped out a strategy designed to target your risk-reward sweet spot, you’ll improve your chances of success by making regular contributions through dollar-cost averaging and rebalancing your portfolio when it gets out of whack. Over time, your capacity for risk may improve, and so may your stomach for it.