Question Of The Month – November , 2008

What Kind Of A Risk Taker Are You?

Successful investing for retirement is investing for the long term--- and that reveals the puzzling question of risk.  The more time you have to reach your retirement goal, the more risk you can afford to take.  But the longer you have to go until retirement, the less risk you really need to take since your nest egg has longer to gain the benefits of compound growth. 

Some investors will make a mistake by taking on too much risk.  Mutual funds and other investments that offer the most potential for long–term growth often carry considerable risk. There's nothing wrong with taking on that risk, as long as you are willing to ride out significant fluctuations in the value of your investments.  But too often investors attracted by the chance for significant gains invest heavily in funds or other assets without really understanding the risks they carry.

Some investors take too little risk.  They will not take on an even modest short-term decline in the value of what they own and as a result, they stick with the most stable funds — which typically offer only modest investment returns.  And those returns may not be enough to stay ahead of inflation over long periods and may thus leave you short of the nest egg you will need to accumulate to help you meet retirement long–term goals. 

A willingness to take some risk in investing is what provides the chance for you to gain an increased return --- providing a better return than you would get with a “riskless” bank certificates of deposit, U.S. Treasury securities or money market funds.  The real risk of retirement investing comes from taking no risk.  When you place your money only in super  safe investments you forfeit your chance of receiving bigger returns and in turn --- perhaps a more secure retirement.  You swap one type of risk --- investment volatility --- for another—the risk that your nest egg performance won’t keep up with inflation – or that you will outlive your retirement nest egg. 

The cool off of the market in 2008 has given many investors a brand new understanding of the word “risk.”  The major U.S. stock market indexes have dropped about 40 percent in one year since the market’s peak in early October 2007.  And this drop, say a number of the experts, is a reminder that we should take a look at our plans and strategy and reevaluate how much risk we can really take in our investment portfolio. 

But we investors are not the only people who have not been able to figure this market out.  Fortune magazine (October 13, 2008) tells us that “at the market low on Sept. 17, only five diversified equity mutual funds --- out of a universe of 9,100 --- had positive total returns for the year, according to Morningstar.”  “The investing world’s best and brightest appear to be just as confused as the rest of us.”

We are more secure when the market if going up.  Risk seems low.  That is human nature.  And long periods of rising prices (l990s) easily disguise our true feelings about risk.  Think back to the 1990s.  We were all very happy when the market was going up – up – up.  But when 2002 arrived and the market headed south, we were not the risk takers we thought we were. 

One of the most important concepts of investing is the relationship between the risk you take and your expected returns. 

Professor John Grable, Kansas State University, an investment risk expert, points out what we all know ---the more risk you take, the larger the potential for gains.  And he also asks the question --- what good is taking risk if investors are going to bail out when the market goes down. 

In the chart which accompanies this month’s question, you will see that in the period 1926 – 2007, large-cap stocks had an annual return of 10.4%.  But, as you will also note, the largest one year loss during that period was 43.3%.  Long-run averages put a mask over the big short-term swings you need to be prepared for.  If you want to participate in the gains in the good times, you need to be aware and prepare for the bad times.  As Larry Swedroe, columnist for Money magazine, points out,  “In 23 of the 82 years from 1926 through 2007, the S&P 500 posted negative returns.  And often these drops can be severe:  Between March 2000 and October 2002, equities shed more than 49% of their value.”  “Bear markets are  like taxes.  They’re painful and inevitable, but ultimately they’re a necessary evil.”

The only guarantee you have is that the market goes up and it also goes down.  Your job as an investor is to manage your risk and your emotions.  In the past two years of so, there were investors who were very happy to buy energy stocks and commodities when the price of oil peaked at $145 a barrel.  But how happy are they now as the price is dropping to about $67 a barrel (10/22/08)? 

Vanguard tests investors' resolve by using dollar figures to show how different asset allocations fared in the last bear market. --- 2000 – 2002. 

For instance, how would you feel if your $100,000 investment lost $33,000 in 2½ years? That's what happened to investors with an 80 percent stock and 20 percent bond portfolio from March 31, 2000, to Sept. 30, 2002. 

After losing that much, would you continue to invest 80 percent of your remaining $67,000 in stocks?

If not, what about a 60-40 stock-bond split? Investors with that portfolio lost nearly $20,000 in the same time frame, he said.

Or would you be most comfortable with a 40 percent stock and 60 percent bond portfolio, which lost $5,000 over that time?

And these are the questions you should ask of yourself as you ponder the question---

What Kind Of A Risk Taker Are You?   Are you a very

conservative, conservative, moderate or an aggressive investor?

“This above all: to thine own self be true, And it must follow, as the night the day, Thou canst not then be false to any man.”  William Shakespeare,  1564 - 1616