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Investments

2002-09-01 10:07:00

Investment risk... how do you properly evaluate it?

:  How should one approach the risk of an investment?

J. Richard Coe Question:  How should one approach the risk of an investment? Answer:  How much investment risk should you assume?  Should your emotions and feelings drive the answer to that question?  Is there a more reliable approach than one's feelings?Most people are risk averse, and for good reason.  Why assume any investment risk?  The only reason to incur investment risk is the possibility of gain.If someone can reach all of their financial goals without taking investment risk that is a wise course of action.  The key word is "all".  Most people cannot reach all of their financial goals without investment risk.  They want more of something, so are willing to incur some risk to get it.  Most people have to assume investment risk to realize even their primary financial goals, let alone all of their goals.In the 1980's I had the impression that millions of Americans were not taking enough investment risk.  Due to apparently attractive interest rates, much money was in short- term instruments.  While short- term rates looked attractive, rates dropped during the decade and people could have made more money in stocks.In the late 1990's many took too much risk.  Stocks climbed higher and higher year after year.  It looked so easy to make money in stocks.  Time-tested principles of diversification were abandoned as many simply joined the technological bandwagon.  Many investors in the '90s had not seen a bear market.They have now seen a bear market of historic proportions.  As the pain became more intense, many belatedly reduced their risk.  In effect they said, "I can't handle this any more."There are different types of risk.  Some risk is prudent; other risk is foolish.  For example, it can be prudent to invest in a diversified equity portfolio, either through individual stocks or funds.  But it is almost always foolish to invest a significant portion of your assets in one stock.There are not many true principles of finance, but the wisdom of diversification is truly a principle of finance.  The old adage is true - we should not put all of our eggs in one basket.  Finance theory can get technical, but it is very helpful to get a handle on the basics.  Simply put, there are two types of risk with stocks.  There is the risk that you get paid for and the risk that you don't get paid for.  Within the world of publicly traded stocks, it is not realistic to expect a return to be associated with risk that can be diversified away.  With each stock there is a market risk (this is inevitable and is the kind of risk that is linked with return).  With each stock there is individual security risk (this can be diversified away by buying other stocks so there is no return expected for this type of risk).If you buy only one stock, you may either make money or lose money.  But you are assuming far more risk than necessary for the return that can reasonably be expected.  On average, if you have only one stock you have more than 3 times the risk of a diversified portfolio.  And what do you get for the extra risk?  Probably nothing.  The stock may go up or down, but you should not expect to be rewarded for the extra risk you have taken.To the extent you take investment risk, you want to be sure it is prudent risk that has the potential for return.  Millions of Americans have lost much of their net worth because they had invested heavily in only one stock such as Enron or WorldCom.  Those losses are probably permanent.  By contrast, people with diversified portfolios have also experienced losses, but there is still potential for market rebounds.  Markets go up and down.  If someone has a diversified portfolio and has the patience to live through the downturns and wait for the rebounds, the losses are only temporary and not "realized".While we should only have "prudent" risk, there is still the question of how much of it we should have.  Investor feelings do matter.  Behavior is important.  If someone will be inclined to liquidate simply because the stock market has dropped, it would be better for that person not to have invested in stocks in the first place, even if it was diversified, "prudent" risk.Many advisors use simple questionnaires to get a handle on someone's willingness to incur risk.  At least one independent online company offers a statistically valid 25 question multiple-choice questionnaire to measure one's willingness to assume risk.While it is very helpful to get an accurate read on risk tolerance, another dimension is even more important and it has nothing to do with emotions or feelings.  Tools are available that simulate 1,000 or more lifetimes with different life expectancies and a wide variety of rate of return assumptions.  The success of one's financial plan depends largely on how long someone will live and what rates of return are realized. Both expectancy and future rates of return are unknowns and can vary greatly.  Through simulation of 1,000 lifetimes it is possible to get a probability analysis.  This tool can be very helpful in determining the amount of investment risk one should have.  For example, the probability analysis might show that someone had a 45% probability of meeting their goals with a 40% equity exposure and a 63% probability of success with a 60% equity exposure.  That would be a good reason to consider increased equity exposure even if one did not feel comfortable with the idea.Too much risk can be detrimental and too little can cause one to fall short of goals.In summary, a wise investor will eliminate unnecessary risk through diversification.  A wise investor will take no more risk than necessary to meet his or her goals.  A wise investor will have an accurate read on one's willingness to assume risk.  A wise investor will decide how much risk to incur in the context of specific goals.  Probability analysis can be used to determine an allocation to improve the odds of meeting important goals.