Investors Must Recall Risk, Investing's Four-Letter Word
By KAREN HUBE Staff Reporter of THE WALL STREET JOURNAL
What four letter word should pop into mind when the stock market takes a harrowing nose dive? No, not those. R-I-S-K. Risk is the potential for realizing low returns or even losing money, possibly preventing you from meeting important objectives, like sending your kids to the college of their choice or having the retirement lifestyle you crave. But many financial advisers and other experts say that these days investors aren't taking the idea of risk as seriously as they should, and they are overexposing themselves to stocks. "The market has been so good for years that investors no longer believe there's risk in investing," says Gary Schatsky, a financial adviser in New York. "And when the market drops hundreds of points and rebounds immediately, that belief is confirmed." The danger is that when the market declines and stays down for months -- as some analysts predict it eventually will -- investors won't be able to meet their short-term financial goals. Or, they will panic and sell their investments as their shares are declining in value, which is the worst possible time. So before the market goes down and stays down, be sure that you understand your tolerance for risk and that your portfolio is designed to match it. Assessing your risk tolerance, however, can be tricky. You must consider not only how much risk you can afford to take but also how much risk you can stand to take. What you can afford depends mainly on your time horizon -- how long before you will need the money. If your investments are targeted for your child's college tuition in three years, for instance, your financial ability to take on risk is low because you may not have time to recover if the value of your portfolio declines. But if you have 10 years before your child heads to college, you can afford to take more risks because you would have plenty of time to ride out dips in the market. Determining how much risk you can stand -- your temperamental tolerance for risk -- is more difficult. It isn't quantifiable. "A variety of behavioral factors come into play," says Richard Bernstein, director of quantitative research at Merrill Lynch & Co. in New York. "If my broker asks me if I want high-risk or low-risk securities, I may say high risk because I don't want to look wimpy." Similarly, some people will gloss over the less impressive details of their investing histories, says Ronald Roge, a financial adviser in Bohemia, N.Y. He routinely asks to see copies of his clients' tax returns to get a reliable account of gains or losses. "The aim is always to find the fine line between greed and fear," he says. To that end, many financial advisers, brokerage firms and mutual-fund companies have created risk quizzes to help people determine whether they are conservative, moderate or aggressive investors. Some firms that offer such quizzes include Merrill Lynch, T. Rowe Price Associates Inc., Baltimore, Zurich Group Inc.'s Scudder Kemper Investments Inc. of New York, and Vanguard Group in Malvern, Pa. "The typical investor may not have ever experienced a negative turn in the stock market. They need to be prepared for that," says Robert Benish, vice president of education programs for Scudder, whose questionnaire is part of a broader investing-education program. "We want to help them understand what risk means to them." Typically, risk questionnaires include seven to 10 questions about a person's investing experience, financial security and tendency to make risky or conservative choices. Some of these risk tests, such as one created by Vanguard (www.vanguard.com), can be found on-line. The benefit of the questionnaires is that they are an objective resource people can use to get at least a rough idea of their risk tolerance. "It's impossible for someone to assess their risk tolerance alone," says Mr. Bernstein. "I may say I don't like risk, yet will take more risk than the average person." Many experts warn, however, that the questionnaires should be used simply as a first step to assessing risk tolerance. "They are not precise," says Ron Meier, a certified public accountant who teaches investing-related courses at the College for Financial Planning in Denver, a unit of Apollo Group Inc., Phoenix. "They are good for leading discussions but not for coming up with a final risk score." The second step, many experts agree, is to ask yourself some difficult questions, such as: How much you can stand to lose over the long term? "Most people can stand to lose a heck of a lot temporarily," says Mr. Schatsky. The real acid test, he says, is how much of your portfolio's value you can stand to lose over months or years. Rather than using percentages, think in dollar terms. "When you convert percentages to figures, often you see very different psychological effects," says Richard Wagener, a financial adviser in Columbia, Md. The idea of a 20% decline on, say, a $150,000 portfolio is more abstract than a $30,000 loss, he says. Financial adviser Glen Clemans of Portland, Ore., says he cites the 1972-1974 bear market to help his clients realize how much they can lose. "I tell my clients to imagine they had put $100,000 in the S&P 500 in November 1972," says Mr. Clemans. He then explains that after the first year, the investment would have been worth $88,000. "I watch to see how they flinch. Then I tell them that the next year, their investment would have been worth $67,000, and ask them 'So now what would you do?' " As it turns out, most people rank as middle-of-the-road risk-takers, say Mr. Clemans and other advisers. "Only about 10% to 15% of my clients are aggressive," says Mr. Roge. For some of the biggest risk-takers, particularly those who say they like to gamble, Mr. Roge recommends creating an "action account" that includes no more than 10% of their assets. Money in the account can be used to speculate in the stock market. "Some investors just love the excitement of getting a stock pick from a brother-in-law, even though they may lose money," says Mr. Roge. "People who need that kind of action should have an outlet for it."
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