Risk
You Can’t Invest Without It
So You Need to Understand How Much You Can Take

By Richard Halverson

Last month I was commenting on mutual funds as a valuable investment tool.  I mentioned briefly in the article that knowing your risk profile is important in selecting the correct fund.  I did not spend much time describing how you can determine what your risk profile is.  It is a very important topic.  There is some form of risk associated with all investments.  Two years ago this article ran on Meridian.  I felt it was a good idea to update it and run it again.

If you read books on the subject of risk you will discover that investment professionals and academicians have many definitions for risk.  In my experience ordinary investors care about only one definition of risk, the risk of losing money. For most investments, like a mutual fund, the risk of losing money is related to the investment’s volatility.  How much does it go up and down?  That is the definition of risk I will focus on in this article.

Any financial plan, no matter how simple or sophisticated, must include consideration of the investor’s ability to take risk.  All investing involves risk.  Here is a fact: the greater the potential reward the greater the potential risk.  You know the old cliché,  “If it seems to good to be true it probably is.”  It is accurate when it comes to investing.  If you believe you have found an investment that will yield big returns with no risk of loss, chances are you don’t really understand the investment.

Investment risk is not bad!  You must take risk to meet your financial goals. The key to successful investing is assuming investment risks that match your risk profile. Figuring out what your risk profile is takes some work.  In my experience when people are asked by a financial planner, “What is your risk profile?”  People rarely know.  From an investment point of view there are three considerations:

1.       Time horizon.

2.       Financial resources.

3.       Tolerance for investment volatility.

Time Horizon

Time horizon refers to how long you can leave the money invested before you will need it.  Generally speaking the longer your time horizon the more risk you can accept.  Stock market investments are a prime example.  Today everybody with a five-year memory knows the stock market can go down.  Some are even starting to believe that it can go up again.  By contrast in 1999 it felt like some investors had come to believe that bear markets had been outlawed.

I am sorry to bore you with statistics because few of us can conceive what the financial planner is babbling about when he/she says, “There is a 22% chance you can experience a 17% loss.”  It is like the weather forecast.  I recently planted grass seed on a hill.  There was only a “20% chance of isolated showers.”  Sounded pretty safe.  About 4:00 P.M. the downpour began.  By midnight there were flood warnings up all over the city.  When it finally stopped raining the next day I figured I had a million drowned grass seeds at the bottom of the hill.  However, it doesn’t seem so funny if it is your 401k at the bottom of the hill instead of $15 of grass seed.

Well, statistics tell an important story so I’ll try to keep it brief.  These stats use 25 years of historical returns for the S&P 500 Stock Index and are based on 5,000 Monte Carlo statistical simulations to project the future.  As a reminder the past is never a perfect predictor of the future.

·         In one year there is nearly a 17% chance you will have a loss in your stock market investment (or all your grass seed will be at the bottom of the hill.)

·         In three years there is still a 3% chance you will have a loss and it might be as much as 25% (and that is a lot of drowned grass seed.)

·         However, statistically, in ten years there is almost 0% chance of a loss (so keep your lawn mower sharp.)

By contrast using the same technique for one-year treasury bonds there is no statistical chance of loss for one, three or ten years.  However, your expected return in treasury bonds is way below stocks for all these time periods.  For example, in 10 years you should easily expect to earn twice as much money in stocks as in treasuries.

The conclusion here is: if you are saving money to pay college tuition and you absolutely must have it next fall, the stock market is probably unacceptably risky.  If you are saving money for your retirement in ten, twenty or thirty years being out of the stock market is probably unacceptably risky.

Financial Resources

Remember all those old clichés like, “It takes money to make money.” Or “The bank will only lend you money if you don’t need it.”  Well, they have some relevance in financial risk taking too.  The people who really need money badly – meaning they really need to get high returns – are the ones who can’t afford to take high risk.

Let me illustrate.  Imagine you have been invited to a friendly coin flipping contest with Bill Gates, the world’s richest man.  Suppose there is prize money that goes to the winner.  The prize money comes from your entry fee, Gates’ entry fee and prize money from the flipping sponsors.  Assume that in this game you stand a chance of winning $20 on a simple coin flip for only a $5 entry fee. You are likely to jump at the chance. You have a 50/50 chance of winning $20 by investing only $5.  The mathematical risk/reward is way in your favor.  If you lose the $5 it is no big deal. (It would be worth it just to meet Bill Gates.)  However, suppose the entry fee is $5 million not $5.  Now the prize money is $20 million. Mathematically the risk/reward is still the same.  At 50/50 the odds are still terrific. BUT you also have a 50/50 chance of losing $5 million! Based on completely unscientific guestamates about the wealth of most Meridian readers losing $5 million would probably be a big deal.  Bill Gates would probably still play.  Losing $5 million to him is still not a big deal. And besides he would probably like to meet you. (Or not.) What entry fee would be too high for you?  $50.  $5 hundred.  $5 thousand.  I doubt your personal risk tolerance is $5 million.  (Forgetting the fact that you are Mormon and don’t believe in gambling in the first place.)

There is another old financial cliché, “Never invest more than you can afford to lose.”  There is some truth in this statement.  Fortunately, for most investments you are not likely to lose everything like you can in a single coin toss.  However, you do need to make some reasonable judgement what the risk of loss is.  You can get a clue by examining the history of this investment or other similar investments.  Then, like the coin flip do not risk more than you can afford to lose – even when the potential reward seems very high.

Your Tolerance for Investment Volatility

This is the most difficult question to be resolved in determining what your risk profile is.  This is your visceral reaction to risk.  Some people react to a substantial decline in their investments by shrugging it off and going on with their lives.  Other people react to a minor setback in a healthy financial portfolio by becoming physically ill with worry.   It is particularly tricky if these two people happen to be married to each other.

Tolerance for volatility is a matter of personality.  There is no right or wrong level of tolerance and no two people are exactly alike. Financial planners would like to be able to quantify their clients’ risk tolerance.  Since the risk inherent in various assets can be quantified this would allow them to use math to accurately prescribe a financial plan.  The desire to quantify the problem is so high that most financial planners will use something to describe tolerance for volatility.  However, studies show that tools for quantifying individual risk tolerance are very crude. So there is a lot of art and guesswork.  Unfortunately, this can lead to erroneous answers and even manipulation if the planner is trying to sell something.  In the end you are the only person that knows yourself well enough to make a really good judgement about your tolerance for financial risk and volatility.  At a minimum if you are working with a professional you must help them in this area.  It is like going to the doctor.  You are the only one who knows where it hurts.

·         Tolerance for risk in one area does not translate to tolerance for risk in another.  For example, you may be a real risk taker when it comes to activities like Bungee Jumping.  But you may be very conservative when it comes to investing.

·         Try to visualize your financial risks as you might other risks.  Recently we were at famous amusement park that has a roller coaster that drops over 300 feet and hits speeds over 90 miles per hour.  Some in the group could just visualize that drop and could hardly wait for the rush.  Others could just visualize that drop and could hardly wait to get out of there.  Some went, some didn’t.  Everyone was happy.  Everyone visualized. Learn to visualize financial risks and rewards, as well.  For example, assume you are making your 401k allocation.  You have the option of putting all your money in a high growth fund that has been booming. The material cautions that the fund may be subject to high volatility.  Assume you currently have $50,000 in your 401k.  Take the statement. Cover the current value with a Post It Note and write in $100,000.  Visualize how you will feel seeing that number on a future statement.  Then write $25,000.  Visualize how would you react to that statement?  If you feel ill you tend toward a low tolerance for risk and vice versa.

·         How much do you worry about money?  Probably you figure you are normal and probably you are – for you.  But you still fall on some scale of normalcy. Think about people you know well.  If you think they tend to worry too much about money then you are probably a financial risk taker.  If you think they are reckless you are probably a financial risk avoider.

·         I believe your risk tolerances change during different periods of your life.  For example, I have seen people’s attitudes towards all kinds of risk change on a dime when the first child comes along.  That realization of responsibility can be profound.  What stage of life are you in?

Figuring out what your risk profile is very important for all investing.  Perhaps you are working with a financial advisor.  The advisor can work for you best if you can help her/him accurately determine your risk profile.  Perhaps you are simply making a selection among available mutual funds for a regular monthly investment and you are doing it on your own.  Your understanding of your risk profile will help you select the correct one.  It is one of the most important elements in being happy with your investment.

At this point it is critical to note that if you are married identifying the correct risk profile is even more difficult.  You and your spouse are counting on the same financial assets for your respective and joint futures. Your demographic statistics may be the same i.e. similar time horizon and financial resources.  But your tolerance for risk will probably be different.  It is important to help everyone be comfortable.  It is not fair for a wife to force her husband to ride on a roller coaster with a 300-foot drop that makes him physically ill.

I must warn you that frequently when people really come to understand risk and their personal risk profile they discover there is a problem.  The problem is that the amount of risk the person should assume to have a chance at meeting their important financial goals is higher – some times much higher – than their risk profile will comfortably allow.  Not taking enough risk may result in not earning enough for an adequate retirement, for example.  Reaching outside their risk profile in an effort to achieve the goal may actually leave them destitute and struggling.  There is no easy answer but ignoring it won’t make it go away.

Investment risk profile is the level of risk you can reasonably take.

Investment risk required is the level of risk inherent in the return that will be required to achieve your goals.

May yours always be in perfect harmony.