Boost Your Returns by Conquering Risk

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Last Updated Sep 16, 2009 5:00 PM EDT

Risk is seldom where we think it is. It can be right in front of us and we won't even realize it. Then, when we imagine that it's lurking around every corner, it may turn out not to be there at all. When were you more preoccupied with risk? Two years ago, when the Dow Jones industrial average hit 14,000 and was about to lose more than half of its value, or last spring, when it fell below 7,000 and was on the verge of a huge gain?

We think we know what risk is, but it’s a complicated phenomenon to grasp. It’s hard to define — like beauty, risk is in the eye of the beholder — and it is even harder to detect or measure.

But it’s worth the effort. Until you get a handle on risk, investment advisers caution, you will never really know how much you are exposed to or how much you want, need, or can stand. That leaves you vulnerable to bad decisions that can put you in the wrong investments at the wrong time. By understanding the risks you face — and, equally important, how you tend to respond to them — you’ll put yourself in a better position to make smart moves and avoid emotionally driven mistakes.

Look in the dictionary and you’ll see risk defined as the chance of suffering some adverse result, such as a financial loss. But gains that accrue at less than the inflation rate are adverse results, too. So are missed opportunities, such as when stocks or other assets soar without you. Inflation risk and opportunity risk are harder to see, so we tend to pay less attention. But they are just as real.

For Harold Evensky, a financial planner at Evensky & Katz Wealth Management in Miami, the key “adverse result” will occur if his clients do not have enough to cover their needs and wants in retirement because they failed to save or invest properly.

“If you can lose your standard of living, that’s a pretty big risk,” he said. In that context, assets that are perceived to be safe, such as cash instruments and bonds, suddenly seem like risky propositions, and a big allocation to stocks seems like a prudent choice. “I try to explain to [clients] that they’re not necessarily taking more risk” in stocks, Evensky said, noting that “people confuse certainty and safety.”

Is Anything Really ‘Safe’?

Short-term bonds and money-market funds “are not necessarily safe, because you’re going to run out of money because inflation is going to eat you alive,” he said. “If you want to do that, it’s fine, but that seems risky to us.” Stocks are deemed riskier than bonds or cash by many investors because stocks trade with more volatility. Risk is often associated with volatility because bigger swings in an asset raise the likelihood that holders will be sitting on a big loss at some point.

Once you realize that all financial moves — including the “safe” investments — carry their own risks, you’ll make better decisions. Evensky assesses an investment’s risk in relation to its reward potential. The payoff for enduring the higher volatility of stocks is long-run returns that have nearly always been higher than those of tamer assets. That’s why advisers encourage long-term investing. If you’re certain not to need your money for a while, then price swings are rendered meaningless and you can still capture those high returns over time.

A common mistake investors make is confusing the perception of risk with risk itself. They tend to think risk is greatest after a big decline when — as we saw in March — the opposite is often true.

“Very often, people identify risk way after it’s too late,” said Henry Herrmann, chief executive of the fund management firm Waddell & Reed. “They understand what it is after it’s happened to them. You see that in the investment business all the time.” Investors bail out of beaten-up markets near the bottom because they overestimate the risk and assume that the present trend will continue. They do the opposite in bull markets, when “money pours in at the top,” Herrmann said.

Will Goetzmann, director of the International Center for Finance at Yale University, pointed to “a common human tendency to focus on recent events and consider them representative.” That tendency may lead humans these days to focus on sources of risk that they seldom factor into their thinking during more ordinary times. One recent event, the Madoff case, should make investors more cognizant of the risk of fraud, he said.

“Madoff’s returns were very steady, but there was a lot of risk,” Goetzmann remarked. Such events “hit without any kind of statistical warning and are not things that have numbers associated with them.”

Know Your Risk Tolerance

Even if you are clear on the risks you face, you still may have trouble judging your tolerance for them. Knowing the markets is one thing; knowing your own mind is something else, especially the part that deals with feelings like greed and fear. Your biggest risk may not be from a falling stock market but from your response to it. An investor who sticks with a steady, low-return portfolio may reap better returns than someone with a higher-returning but more volatile portfolio who sells after a market decline and misses the next rally.

“What risk tolerance is speaking about is your emotional makeup,” Herrmann said. “No matter whom I talk to, I never get the whole truth because they don’t even know the whole truth.” Financial planners use questionnaires and interviews to try to assess risk tolerance. They tease out such tangible, dollars-and-cents information as how secure investors are in their jobs and how big their net worth is.

They also try to gauge their ability to withstand losses of various sizes and how frustrated they would be to miss out on a big gain. Planners say it’s hard to trust the responses, though, because investors often fail to put their money where their mouths are and keep it there.

“People will say a lot of things about what they’re comfortable with,” said Matt Havens, a partner at Global Vision Advisors in Hingham, Massachusetts. “Even if they say they know their portfolio can go down 20 percent to 30 percent, you don’t know if they really process it. You have to look at their experience and what they’ve owned, what their best and worst experiences in investing have been.”

Evensky, the Miami planner, advises investors to play a game of brinkmanship with themselves. You should find “that level of pain, when everything’s going wrong, at which [you] will be miserable but won’t say you want out of the market,” he says. If you are honest with yourself about your tolerance for risk, investment advisers say, the odds are better that you will make the right investment plan and follow through on it.

“Structure something that allows you to sleep at night and there’s a much higher probability that you’ll stick with it,” Herrmann said. “That’s when you get results. Come up with a [plan] you can live with and, over time, you’ll meet your goal.”

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