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As you decide how much to invest in stocks, a lot supposedly rides on whether you have knees of jelly or nerves of steel. But this notion of risk tolerance is a dangerous idea. For proof, look no further than our reaction to recent market movements.
Our tolerance for risk, it seems, has plunged along with the market. But clearly, that doesn't mean we should cut back on stocks. If we slashed our stock-market exposure every time we felt queasy, we would buy high, sell low and garner disastrous investment results.
- "After the stock market has gone up, people think that the probability of the market continuing to go up is high."
- "When the market goes down, people think it will continue to go down."
What to do? As we settle on our portfolio's stock allocation, maybe we should forget about risk tolerance and instead focus on four other factors.
1. Taking Aim: "This fixation on risk isn't getting us any-place. Instead, people should think about the goals they have." You might want a cash reserve to cover emergencies and help you sleep better at night. But you also want to amass enough for retirement, which means buying stocks in the hope of notching high returns. "One goal is to avoid being poor. The other goal is having at being rich. Each goal is desirable. The question is, how do we allocate our portfolio between these two goals?"
2. Hitting the Target: "People don't understand risk very well. Most people will underestimate the risk of bond investments, because they don't understand interest-rate risk. And even after the great performance of the past few years, they'll overestimate the risk of a diversified stock portfolio over the long term."
It is better for you to be educated about risk and figuring out what sort of investment returns you need to meet your goals. You then have a mix of stocks and conservative investments that you think will generate the returns you need. "At that point, you typically change your professed tolerance for risk, rather than changing your goals. You can see the tie-in between the portfolio's risk and the accomplishment of your goals. It provides the motivation to take risk and stay invested when things look grim." Still there is a downside to this approach. "Once you have the portfolio that is most likely to meet their future needs is an aggressive portfolio, you tend to ignore short-term risks. But the problem is, it's these short-term events that you react to."
3. Biding Time: As you decide how to divvy up your money between stocks and more-conservative investments, time is a critical factor. Even if you are an aggressive investor and you need high returns to meet your goals, stocks may not be a wise choice if you have a short-time horizon. "Any money needed in three years or less should be saved rather than invested, and that means Treasury bills, money-market funds and certificates of deposit. But your time horizon is longer than you think. Your kid may be three years from college. But you won't pay the last bill for seven years."
4. Pick a Reasonable Range: No matter what your age or professed risk tolerance, experts typically recommend that long-term investors have 50% to 90% in stocks. Sound like a lot in equities? Initially, you may not be comfortable with such hefty stock exposure. But with time, you should get used to the market swings. And the fact is, without the stocks, you may not amass enough to reach your goals. "You may indicate that you are very risk averse, but then you may not be able to afford to be that conservative."
Source: Jonathan Clements, The Wall Street Journal, June 6, 2000.
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