Showing posts with label risk tolerance. Show all posts
Showing posts with label risk tolerance. Show all posts

Friday 26 June 2020

Know your Investment Profile

Your investment profile

Define your investment profile by identifying:
1.  Your goals and constraints
2.  Your risk ability and tolerance
3.  Your cognitive biases and their impact on your emotions.


Profiling:  everyone is unique

Differences go beyond the level of wealth and stem from:

  • 1.  Age
  • 2.  Education
  • 3.  Phase of life
  • 4.  Profession
  • 5.  ...


Financial situation as the core of your profile

1.  A very wealthy person with relatively little planned expenses

  • Will be able to take considerable investment risk, as you have enough funds aside to absorb potential losses.
  • Will be said to have a "high risk ability"


2.  A person with limited wealth and a large part of his assets reserved for financial commitments:

  • Can only take limited investment risk, as he lacks funds to cover potential losses
  • Will be said to have a "low risk ability"

Ranking the objectives is also key

1.  List your objectives and rank them by degree of priority:
  • Saving for retirement
  • Providing for children's education
  • Purchasing real estate objects

2.  Risk tolerance will be:
  • High for less important objectives
  • Low for important objectives


Investment horizon:  the longer, the better!

1.  The longer the investment horizon, the higher the risk ability
  • .... as investments may recover from potential losses

2.  The shorter the investment horizon, the lower the risk ability
  • .....  as investments cannot recover from potential losses.
3.  Unless you want to speculate ... but at your own risk!




Cognitive biases and the 3 steps in investing

Cognitive biases affect investment decisions when:

1.  Defining the investment universe
  • Choosing which asset classes / securities are taken into consideration

2.  Constructing the optimal investment strategy
  • Forecasting expecting returns and risk

3.  Adjusting and rebalancing the portfolio.



Cognitive biases:  defining the investment universe

When defining the assets universe you want to invest in:
  • You tend to over-invest in local companies (home bias)
  • You tend to overweight recent information (recency bias)

You should get out of your comfort zone and do extensive research on securities which may not necessarily be close to your home, nor provide readily available information.



Cognitive biases:  constructing the portfolio

When making forecasts:
  • You may be influenced by recent data, which may not be relevant (anchoring bias)
  • You tend to be over-confident (overestimating expected returns and / or underestimating risk)
  • You tend to look for evidence which will confirm our beliefs and ignore information that contradicts them (confirmation bias)
Look for the black swan!



Cognitive biases:  rebalancing

When rebalancing the portfolio:
  • You tend to overestimate the value of assets you own and underestimate the value of (similar) assets you do not own (endowment effect)
  • You tend to sell winning positions too soon and hold onto losing positions for too long (disposition effect)


The right question to ask yourself

For example:  

You bought 1000 Nokia shares at 30 EUR.  The stock goes to 60 .. and then drops to 20 EUR.  The question to ask yourself is:

"If I had 20,000 EUR today, would I purchase 1000 Nokia shares?"
  • If you answer "yes", then keep the position.
  • If you answer "no", then sell it.



Conclusions

Before constructing a portfolio, you need to define your
  • Objectives
  • Risk ability and tolerance

You should be aware that you are influenced by cognitive biases which may lead to sub-optimal investment decisions.

You should try to adjust as much as possible for these biases.




Friday 28 April 2017

Risk Objectives

An example of an absolute risk objective would be that the client does not want to lose more than 5% of her capital over a particular period.

Relative risk objectives relate risk to a certain benchmark that represents an appropriate level of risk.

Risk tolerance is a function of BOTH:

  • a client's ability to take risk, as well as,
  • her willingness to take risk.

Ability to take risk

The ability to take risk is a function of several factors including:
  • time horizon,
  • expected income, and 
  • net worth.
Generally speaking, a client with a longer time horizon, high expected income and greater net worth has a greater ability to bear risk.


Willingness to take risk

A client's willingness to bear risk, on the other hand, is based on more subjective factors including 
  • her psychological makeup and 
  • level of understanding of financial markets.



4 scenarios:

1.  Ability to take risk - below average.  Willingness to take risk - below average
The investor's overall risk tolerance is below average

2.  Ability to take risk - above average.  Willingness to take risk - above average
The investor's overall risk tolerance is above average

3.  Ability to take risk - below average.  Willingness to take risk - above average
The investor's overall risk tolerance is below average

4.  Ability to take risk - above average.  Willingness to take risk - below average
The investment manager should explain the conflict and implications to the client.



When there is a mismatch between a client's ability and willingness to take risk, the prudent approach is to conclude that the client's tolerance for risk is the lower of the two factors.

Any decisions made must be documented.






Sunday 24 June 2012

Portfolio Management - Return Objectives and Investment Constraints


Return objectives can be divided into the following needs:
  1. Capital Preservation - Capital preservation is the need to maintain capital. To accomplish this objective, the return objective should, at a minimum, be equal to the inflation rate. In other words, nominal rate of return would equal the inflation rate. With this objective, an investor simply wants to preserve his existing capital.
  1. Capital Appreciation -Capital appreciation is the need to grow, rather than simply preserve, capital. To accomplish this objective, the return objective should be equal to a return that exceeds the expected inflation. With this objective, an investor's intention is to grow his existing capital base.
  2. Current Income -Current income is the need to create income from the investor's capital base. With this objective, an investor needs to generate income from his investments. This is frequently seen with retired investors who no longer have income from work and need to generate income off of their investments to meet living expenses and other spending needs.
  1. Total Return - Total return is the need to grow the capital base through both capital appreciation and reinvestment of that appreciation.

Investment ConstraintsWhen creating a policy statement, it is important to consider an investor's constraints. There are five types of constraints that need to be considered when creating a policy statement. They are as follows:
  1. Liquidity Constraints Liquidity constraints identify an investor's need for liquidity, or cash. For example, within the next year, an investor needs $50,000 for the purchase of a new home. The $50,000 would be considered a liquidity constraint because it needs to be set aside (be liquid) for the investor.
  2. Time Horizon - A time horizon constraint develops a timeline of an investor's various financial needs. The time horizon also affects an investor's ability to accept risk. If an investor has a long time horizon, the investor may have a greater ability to accept risk because he would have a longer time period to recoup any losses. This is unlike an investor with a shorter time horizon whose ability to accept risk may be lower because he would not have the ability to recoup any losses.
  3. Tax Concerns - After-tax returns are the returns investors are focused on when creating an investment portfolio. If an investor is currently in a high tax bracket as a result of his income, it may be important to focus on investments that would not make the investor's situation worse, like investing more heavily in tax-deferred investments.
  1. Legal and Regulatory - Legal and regulatory factors can act as an investment constraint and must be considered. An example of this would occur in a trust. A trust could require that no more than 10% of the trust be distributed each year. Legal and regulatory constraints such as this one often can't be changed and must not be overlooked.
  1. Unique Circumstances Any special needs or constraints not recognized in any of the constraints listed above would fall in this category. An example of a unique circumstance would be the constraint an investor might place on investing in any company that is not socially responsible, such as a tobacco company.

The Importance of Asset AllocationAsset Allocation is the process of dividing a portfolio among major asset categories such as bonds, stocks or cash. The purpose of asset allocation is to reduce risk by diversifying the portfolio. 

The ideal asset allocation differs based on the risk tolerance of the investor. For example, a young executive might have an asset allocation of 80% equity, 20% fixed income, while a retiree would be more likely to have 80% in fixed income and 20% equities.
Citizens in other countries around the world would have different asset allocation strategies depending on the types and risks of securities available for placement in their portfolio. For example, a retiree located in the United States would most likely have a large portion of his portfolio allocated to U.S. treasuries, since the U.S. Government is considered to have an extremely low risk of default. On the other hand, a retiree in a country with political unrest would most likely have a large portion of their portfolio allocated to foreign treasury securities, such as that of the U.S.


Read more: http://www.investopedia.com/exam-guide/cfa-level-1/portfolio-management/return-objectives-investment-constraints.asp#ixzz1yfCssLbg

Portfolio Management - The Portfolio Management Process


The portfolio management process is the process an investor takes to aid him in meeting his investment goals.

The procedure is as follows:
  1. Create a Policy Statement -A policy statement is the statement that contains the investor's goals and constraints as it relates to his investments.
  2. Develop an Investment Strategy - This entails creating a strategy that combines the investor's goals and objectives with current financial market and economic conditions.
  3. Implement the Plan Created -This entails putting the investment strategy to work, investing in a portfolio that meets the client's goals and constraint requirements.
  4. Monitor and Update the Plan -Both markets and investors' needs change as time changes. As such, it is important to monitor for these changes as they occur and to update the plan toadjust for the changes that have occurred.

Policy StatementA policy statement is the statement that contains the investor's goals and constraints as it relates to his investments. This could be considered to be the most important of all the steps in the portfolio management process.The statement requires the investor to consider his true financial needs, both in the short run and the long run. It helps to guide the investment portfolio manager in meeting the investor's needs. When there is market uncertainty or the investor's needs change, the policy statement will help to guide the investor in making the necessary adjustments the portfolio in a disciplined manner.

Expressing Investment Objectives in Terms of Risk and ReturnReturn objectives are important to determine. They help to focus an investor on meeting his financial goals and objectives. However, risk must be considered as well. An investor may require a high rate of return. A high rate of return is typically accompanied by a higher risk. Despite the need for a high return, an investor may be uncomfortable with the risk that is attached to that higher return portfolio. As such, it is important to consider not only return, but the risk of the investor in a policy statement.

Factors Affecting Risk ToleranceAn investor's risk tolerance can be affected by many factors:
  • Age- an investor may have lower risk tolerance as they get older and financial constraints are more prevalent.
  • Family situation - an investor may have higher income needs if they are supporting a child in college or an elderly relative.
  • Wealth and income - an investor may have a greater ability to invest in a portfolio if he or she has existing wealth or high income.
  • Psychological - an investor may simply have a lower tolerance for risk based on his personality.


Read more: http://www.investopedia.com/exam-guide/cfa-level-1/portfolio-management/portfolio-management-process.asp#ixzz1yfBLNFTr

Tuesday 7 February 2012

Top 10 Things to Do Before You Invest

Top 10 Things to Do Before You Invest
by Michele Cagan, CPA

1. Pay off every penny of credit card debt. You'll earn sky-high (18 to 22 percent!) returns just by paying your credit card balance in full rather than making the minimum monthly interest-laden payments.

2. Build yourself an emergency fund. Start a separate bank account for this purpose alone. It should have enough money to cover at least three to six months of living expenses.

3. Set up and follow a household budget. Keep track of where your money comes from and (even more important) where it's going.

4. Set clear financial goals. Whether you want to save for a new car this year or retirement twenty years from now, you need to know why you're investing.

5. Determine your time frame. How long your money will be working for you plays a key role in designing the best portfolio.

6. Know your risk tolerance. Investing can bring about as many downs as ups, and you have to know just how much uncertainty you can comfortably stand.

7. Figure out your asset allocation mix. Before you start investing, know what proportion of your portfolio will be dedicated to each asset class (like stocks, bonds, and cash, for example).

8. Improve your understanding of the markets. That includes learning about the big picture, such as the global political and economic forces that drive the markets and affect asset prices.

9. Set up your brokerage account. Whether you decide to start out with a financial advisor or take a more do-it-yourself approach, you'll need to have an open brokerage account before you can make your first trade.

10. Analyze every investment before you buy it. Buy only investments that you have researched and fully understand; never risk your money on an unknown.

http://www.netplaces.com/investing/planning-for-success/top-ten-things-to-do-before-you-invest-1.htm

Wednesday 28 September 2011

5 "New" Rules for Safe Investing

1. Buy and Hold
History has repeatedly proved the market's ability to recover. The markets came back after the bear market of 2000-2002. They came back after the bear market of 1990, and the crash of 1987. The markets even came back after the Great Depression, just as they have after every market downturn in history, regardless of its severity.

Assuming you have a solid portfolio, waiting for recovery can be well worth your time. A down market may even present an excellent opportunity to add holdings to your positions, and accelerate your recovery through dollar-cost averaging Read: 5 "New" Rules For Safe Investing

Read more: http://www.investopedia.com/slide-show/5-new-rules/buy-and-hold.aspx#ixzz1ZC8MiDKw


2. Know Your Risk Appetite
The aftermath of a recession is a good time to re-evaluate your appetite for risk. Ask yourself this: When the markets crashed, did you buy, hold or sell your stocks and lock in losses? Your behavior says more about your tolerance for risk than any "advice" you received from that risk quiz you took when you enrolled in your 401(k) plan at work.

Once you're over the shock of the market decline, it's time to assess the damage, take at look what you have left, and figure out how long you will need to continue investing to achieve your goals. Is it time to take on more risk to make up for lost ground? Or should you rethink your goals? Read: 5 "New" Rules For Safe Investing

Read more: http://www.investopedia.com/slide-show/5-new-rules/risk-appetite.aspx#ixzz1ZC8qhVwu

3. Diversify
Diversification is dead … or is it? While markets generally moved in one direction, they didn't all make moves of similar magnitude. So, while a diversified portfolio may not have staved off losses altogether, it could have helped reduce the damage.

Holding a bit of cash, a few certificates of deposit or a fixed annuity along with equities can help take the traditional strategic asset allocation diversification models a step further.
Read: 5 "New" Rules For Safe Investing

Read more: http://www.investopedia.com/slide-show/5-new-rules/diversify.aspx#ixzz1ZC921poy

4. Know When to Sell
Indefinite growth is not a realistic expectation, yet investors often expect rising stocks to gain forever. Putting a price on the upside and the downside can provide solid guidelines for getting out while the getting is good. Similarly, if a company or an industry appears to be headed for trouble, it may be time to take your gains off of the table. There's no harm in walking away when you are ahead of the game. Read: 5 "New" Rules For Safe Investing

Read more: http://www.investopedia.com/slide-show/5-new-rules/know-when-to-sell.aspx#ixzz1ZC9IVW7b

5. Use Caution When Using Leverage
As the banks learned, making massive financial bets with money you don't have, buying and selling complex investments that you don't fully understand and making loans to people who can't afford to repay them are bad ideas.

On the other hand, leverage isn't all bad if it's used to maximize returns, while avoiding potentially catastrophic losses. This is where options come into the picture. If used wisely as a hedging strategy and not as speculation, options can provide protection. Read: 5 "New" Rules For Safe Investing

Read more: http://www.investopedia.com/slide-show/5-new-rules/leverage.aspx#ixzz1ZC9XvuWx

Everything Old Is New Again
In hindsight, not one of these concepts is new. They just make a lot more sense now that they've been put in a real-world context.

In 2009, the global economy fell into recession and international markets fell in lockstep. Diversification couldn't provide adequate downside protection. Once again, the "experts" proclaim that the old rules of investing have failed. "It's different this time," they say. Maybe … but don't bet on it. These tried and true principles of wealth creation have withstood the test of time.
Read: 5 "New" Rules For Safe Investing

Read more: http://www.investopedia.com/slide-show/5-new-rules/old-is-new.aspx#ixzz1ZC9pYbAD

Investing can (and should) be fun. It can be educational, informative and rewarding. By taking a disciplined approach and using diversification, buy-and-hold and dollar-cost-averaging strategies, you may find investing rewarding - even in the worst of times.

Read more: http://www.investopedia.com/slide-show/5-tips-for-diversifying-your-portfolio/conclusion.aspx#ixzz1ZCCNZVfl

Friday 31 December 2010

What Is Your Risk Tolerance?

It is conventional wisdom that a younger investor can take more risk than an older investor thanks to a longer time horizon. While this may be true in general, there are many other considerations that come into play. Just because you are 65 doesn't mean you should shift your investment portfolio to conservative investments. Growing life expectancies and advancing medical science mean that today's 65-year-old investor may still have a time horizon of more than 20 years.


So, how does an individual investor determine his or her risk tolerance? Let's take a look.

Read on here.

Tuesday 7 December 2010

Investing with the big picture in mind

Investing with the big picture in mind
Posted on November 6, 2010, Saturday

YOU don’t have to be an expert to get started, but it helps to know the basics before you set a plan for investing. Since the whole idea of investing can be overwhelming and intimidating for anyone who has never done it, try taking small steps.

Here are some basic Do’s

•Do:

•Get some financial education.

•Invest some time, then money.

•Read books and newspapers.

Attend seminars.

Get together with other like-minded people to learn about investment choices including the stock market, property or even a business.

You might also consider hiring a professional, like a financial planner to go through your current financial situation and goals, and work out a detailed financial plan for you. Besides giving you a professional perspective of your financial health, a good financial planner will know the kind of products in the market that will suit you.

But professional help doesn’t come cheap. So the best option would be to get a recommendation from neutral or independent sources such as the Financial Planning Association of Malaysia (FPAM) or the Securities Commission Malaysia before settling on a planner.

Always remember the three important principles of investing:

1. Investment Goals

What is the purpose of your investment? Is it to achieve high dividend yields or a consistent income yield? Once you’ve determined your short-term and long-term objectives, you can identify suitable investments, the level of risk you can tolerate, and what your expectations are.

2. Know your risk tolerance

High returns come with equally high risk. Realise your ability and willingness to lose some or all of your original investment in exchange for greater potential returns.

If you’re an aggressive investor, or one with a high-risk tolerance, a well-diversified equity fund should take up the majority of your portfolio. If you can take on only a moderate degree of risk, then perhaps a hybrid investment plan such as a 50:50 investment portfolio in a moderate risk fund with significant cash savings in a bank account is your calling.

3. Time horizon

Decide on how long you intend to invest and what stage of your life you’re at. If you are saving up for your daughter’s education in which you will need it in the near future such as within five years, then, you would likely to take on less risk because of a shorter time horizon. Also, maintain at least six month’s income in an easily accessible deposit account or put your money in liquid investments such as unit trust funds. This will allow you to have access to your money in the event of emergencies.

Here are two examples* to give you a general idea:

Scenario 1:

Sharon decides to start investing a sum of RM500 monthly, in an investment vehicle that will yield her an average of eight per cent per annum over the next 30 years till retirement. At the end of 30 years, the total sum of her investment would have amounted to RM750,000.

Scenario 2:

If Sharon decides to start investing five years later, a sum of RM500 monthly, in a similar investment vehicle that will yield her an average of eight per cent per annum over a period of 25 years till retirement, her total nest egg would have only amounted to RM478,000 due to the loss of an additional five years in compounded growth.

* Source: Investment Calculator from HwangDBS Investment Management corporate website www.hdbsim.com.my/tools/general-investment

This article is brought to you by HwangDBS Investment Management, your Asian Financial Specialists; we believe you deserve to live the life you want.

http://www.theborneopost.com/?p=73323

Sunday 7 November 2010

Rational Thinking about Irrational Pricing

Depressed investors cause depressed stock market prices.

Selling pressure mounts and drives prices down.  Investors possessing even modest degrees of aversion to loss capitulate quickly, and the less fearsome succumb soon after.

A downward spiral ensues.

Value investors avoid these scenarios by forming a clear assessment of their averseness to loss.  

Only having assessed this characteristic honestly do they brave the choppy waters of stock picking.  

One way to grasp one's own loss aversion is to recognize that most people experience the pain of loss as a multiple compared to the joy of gain.  The average person greets losses with aversion on the order of about 2.5 times their reception of winnings.

The greater one's loss aversion, the greater value investing's appeal.  For the most acutely loss-averse investors, pure value investing is most suitable (Graham was extremely risk averse).

Tuesday 13 July 2010

Understand Your Risk Capacity and Risk Tolerance

You must stay invested in the securities markets to earn market risk premiums

The securities markets pay risk premiums. You have to have your money invested and at risk to be paid a risk premium.

Attempting to avoid risk or losses by jumping in and out to "time the markets" does not work. Scientific finance studies demonstrate the both amateurs and professionals are lousy at market timing.

Historically, U.S. securities markets have paid substantial risk-adjusted returns or risk premiums to investors. While risk premiums have been substantial, they have occurred irregularly. There have been intervening periods of losses, some of which were substantial. (See: How stable have common stock equity risk premiums been over time?)

To earn market risk premiums, your assets must be invested and exposed to potential risk or loss. The more risk you can tolerate, then the higher your potential return and perhaps the rougher the investment road you may travel. Those who have better emotional tolerance for asset volatility can more easily weather market sell-offs.

Practical considerations will also affect your tolerance of investment risk.

In difficult times, whether you need to liquidate risky assets at depressed prices will depend on your expenses and on your other other holdings of less risky, salable assets. Paying necessary living expenses and taxes are good reasons to withdraw funds. Trying to time the markets for a better return is not a good reason.

If you do not need to take out money during a market retreat and recovery cycle, then risk tolerance is solely emotional. For a risk tolerant investor with stable earned income, the recent bubble crash was just a few years of unpleasantness, if he or she was fully diversified and, therefore, not heavily loaded with technology and communications equities. The same, however, could not be said for those who were poorly diversified and also found themselves to be highly risk averse, when risk actually happened. This is especially true, if job loss forced the liquidation of assets at depressed values.

To some degree, all sane individual investors are averse to risk, so risk tolerance is a relative rather than absolute issue.

Therefore, you need to judge your preference or tolerance for risk relative to other investors. While very few people like investment risk, those who can tolerate it better are those who will be less uncomfortable when risk happens from time to time and market values decline by a little or a lot. Tolerating the potential for loss is the cost that investors occasionally pay so that they are always at the table, when the markets deliver their positive rewards.

The vast bulk of individual investors’ publicly traded investment assets are held in the primary cash, fixed income, and equity financial asset classesin the form of individual securities or funds. Your relative investment risk tolerance should influence how your assets are allocated among these primary financial asset classes. If your actual asset allocation is more risky than your risk tolerance, you may not be able to handle the downturns. You might panic, when you should stand firm. If your asset allocation is less risky than your risk tolerance, then you are likely to need to spend less and save at a higher rate to reach your goals.

Nothing is certain about this process, and that is the nature of investment risk. However, the scientific investment literature is relatively clear on certain points. Amateur and professional investors are just not good at timing changes in the markets. Active strategies that attempt to time market turns have under-performed continuous investment strategies. Consistently and profitably calling serial market turns correctly has been a skill beyond mere mortals and certainly beyond the skill of even the most proud of professional and individual investors.


It is better to buy into the asset markets in proportion to your preferred asset allocation and risk tolerance and to stay in the securities markets through thick and thin.

Trying to sit on the sidelines and jump in when things seem safe simply does not work. When things seem safer, they also seem safer to others. In this situation, securities prices will have already reflected this confidence. Most of the "upside juice" or risk premium will already be reflected in current asset prices and only current securities holders will have been paid. (See: Introduction to investment valuation and securities risk)

The converse of trying to jump out to avoid the downturns also does not work. Real-time securities markets are auctions about the expected value of future securities returns. Particularly toward the downside, markets can react extremely rapidly. Getting out in time does not work, because it is usually too late when you realize you should have sold. Worse, however, you might jump out too early and be absent from the table when the market moves upward. Staying in the markets just tends to work better.

If you are more highly risk averse, it is more appropriate for you to select an asset allocation that reflects your relatively higher risk aversion.

You would hold a relatively small portion of your assets in the more risky equity asset class. Therefore, you might be more comfortable and more able and likely to keep your smaller equity allocation invested at all times. Having a smaller, but sustained exposure to equity assets tends to work much better for the more risk averse investor, compared to jumping in and out of the equity markets in larger proportions.

If you stay out of the markets due to such fears, then you are likely to need to save far more to reach your goals. Over-cautiousness is not a free ride. There is never a safe time to be in the markets, because investing is always inherently risky. There is never a safe time to be out of the markets, because you cannot earn investment risk premiums on the cash under your mattress. (See: VeriPlan helps your to compare investment risk-return tradeoffs)

Finally, you should periodically rebalance you assets back toward your planned asset allocation proportions.

To minimize the negative impacts of investment transactions costs and taxes, you should rebalance infrequently and in a planned manner that anticipates deposit and withdrawal transactions that you would need to do anyway for other reasons.

If you want to understand your personal asset allocation and risk-return tradeoffs over your lifetime, VeriPlan provides powerful, automated "what-if" planning facilities. You can rapidly develop and analyze a range of fully personalized scenarios to see whether your asset allocation strategy would achieve your objectives with a level of risk that is acceptable to you. VeriPlan provides five adjustable and fully automated mechanisms to determine your preferred lifecycle asset allocation. VeriPlan gives you full control over rates of asset returns and asset return variability, and it automatically rebalances your assets annually. It even projects the annual expense coverage by your safer cash and bond assets throughout your lifecycle.

___________________________________________________________________
http://www.theskilledinvestor.com/ss.item.174/you-must-stay-invested-in-the-securities-markets-to-earn-market-risk-premiums.html

Friday 26 March 2010

Allocate funds wisely, enjoy your golden years

26 Mar 2010, 0427 hrs IST, Lovaii Navlakhi,


Let us take the case study of a 65-year old and analyse the same. Mrs X has Rs 50 lakh and has invested the same in different products. Each of these has different time horizons and varying rates of return; some are taxable and some are tax-free. Mrs X requires Rs 25,000 pm to manage her lifestyle. 

Regular Cash Flow 

At this moment, she may be quite relaxed as her investments are earning more than her required earnings of Rs 25,000 per month. There could be some issues in terms of regularity of the income, as some of the interest payouts are not monthly. Returns from mutual funds may not be regular too, but in this case is a buffer.

Asset Allocation 

The portfolio of Rs 50 lakh has just 12% of the assets in equity, and hence, is a conservative portfolio considering Mrs X’s age. Since this seems sufficient to meet her goals, we are fine with her investment in fixed income instruments to the extent of 88%. There is, of course, a possibility that Mrs X has a running PPF account in which she can deposit the returns from her equity MFs and continue to earn 8% tax-free returns. As one is aware, the maximum that one can add in a PPF account in a financial year is Rs 70,000.

Taxable Income 

The returns from equity MFs by way of dividends are tax free. The income subject to tax amounts to Rs 3,42,500 for the year. However, Mrs X can take benefit of the Rs 1 lakh invested in ELSS under Section 80C (even investment in PPF can get the same benefit, subject to a maximum of Rs 1 lakh at present), and thus have a taxable income of Rs 2,42,500. Since Rs 2,40,000 of income is exempt for senior citizens, Mrs X will pay a tax on only Rs 2,500 @ 10%. Thus, her returns of 8.3% on her portfolio are virtually tax-free.

Liquidity Analysis 

We assume that Mrs X will live to the age of 90 years, and hence she needs this money to last her for the next 25 years. Prima facie, earning a return of Rs 3 lakh per annum does not seem difficult. However, we have not considered the rate of inflation — if it is 6.5% p.a, the funds will last her 20 years. Further, in case she needs Rs 5 lakh as medical emergency, the money will run out in 18 years. An alternative suggestion to Mrs X will be to increase her equity allocation to 25%, and push her portfolio returns to 9% p.a. That way, her funds last her for 25 years, if inflation remains at 5% p.a.

A financial planner will evaluate the portfolio from multiple perspectives such as returns, risks, liquidity, taxability and even longevity; and approaching one could give you peace of mind, and a greater piece of the action on earth. Get one today!

The author is the MD & Chief Financial Planner of International Money Matters Pvt Ltd. 



http://economictimes.indiatimes.com/articleshow/5725337.cms

Friday 12 March 2010

A Long Look at Risk: Avoid making the wrong choices at precisely the wrong moments.

A Long Look at Risk 

Most of us aren’t honest with ourselves about how much investment risk we can handle. Even worse, we tend to change our minds at market tops and bottoms, making the wrong choices at precisely the wrong moments.

An accurate assessment of risk is important. But you can view risk in many ways.

RISK CAPACITY:  David B. Jacobs of Pathfinder Financial Services in Kailua, Hawaii, usually starts with risk capacity. Young people have a great deal of risk capacity, since they have their whole career ahead of them to make up for any mistakes. A football player might have much less risk capacity, since he could have only a few years of high earnings. And some retirees have plenty of risk capacity, if they have a solid pension.

RISK NEED:  Then Mr. Jacobs moves to risk needNeed is driven by goals.Someone with no heirs and $20 million in municipal bonds might not care so much about significantly growing the portfolio. But if that person suddenly becomes passionate about a cause, he or she may want to double that amount in a decade to create an endowment or put up a building.

RISK TOLERANCE:  Only then does risk tolerance become a factor. “You have to help people visualize what the risk means,” Mr. Jacobs said. “If a year from now, your $1 million is $700,000, how would it change your life? Does that mean you can’t go visit your grandchildren? I’m trying to dig down and make people think of exactly what their day would be like.”

Friday 5 February 2010

Knowing one's risk tolerance is important

The KLCI shot up quickly from around 1250 at the start of the new year 2010 to peak around 1300.  This was a rise of about 4% in less than a month.  Except for those were already invested last year riding the market on the uptrend, those who invested in January would have seen their gains evaporated very quickly at the beginning of February.

Dow Jones dropped 2% yesterday.  The world markets are expected to react similarly today.

Knowing one's risk tolerance is important.

Day traders will be absent today.  Momentum traders who are out of the market will probably stay sideline today.  Those still in the trade will have to make decisions when to terminate their trades based on their own established criterias related to current events.  What of the long term trades (long term buy and hold investors)?  That depends on their risk management and risk tolerance profile.

Links:
What Main Street investors did during and after the recent bear market

The buy-and-hold strategy
http://myinvestingnotes.blogspot.com/2010/02/buy-and-hold-strategy.html

Saturday 30 January 2010

What money means to you? Answer 10 simple questions.

In order to really make your money work for you, it is important to try and get
  • to know more about yourself and
  • your relationship with money. 
Some "money psychology" should help you to deal with your financial affairs in a smart way.

To find out more about your investment orientation and your relationship with money, answer the 10 simple questions below as honestly as possible.  This will also help set the necessary guidelines for your investment portfolio.

Time horizon
Questions 1 - 5

Risk tolerance
Questions 6 - 8

Investment Objectives
Questions 9 - 10

http://spreadsheets.google.com/pub?key=tr9oMvjAsDJvkcPgXdd763A&output=html


Your total score tells you more about yourself.

Less than 10:  You cannot afford to make mistakes
Between 10 and 20:  You are carefully weighing up your options.
More than 20:  You want to grow bigger and better.

Risk Tolerance

Time is not the only factor that affects the risk you take when you invest.

Your own tolerance of risk is an important factor.

Risk is the measurement of your willingness to see your investments shrink in the short-term, even though you know they will increase in the longer term. 

You need to have some idea of your level of risk tolerance.

Be realistic: adjust your investment objectives to fit in with your time horizon and risk tolerance level.

You also have to realise that you need to align your time horizon, risk tolerance and investment objectives. 

You might have a very short time horizon before retirement and a low risk tolerance, you might want to see significant capital growth. 

It is important to be realistic:  you have to adjust your investment objectives to fit in with your time horizon and risk tolerance level.

This also means you will have to find a balance between the risk you are prepared to take and your preferred returns.  Risk and reward are always at opposite end of the scale - the higher the risk, the higher the potential return, and the lower the risk, the lower the expected return.

Therefore, the importance of you knowing more about who you are and how you want your money to work for you at this stage in your life. 

Three most important personal factors to consider: Your Time Horizon, Risk Tolerance and Investment Objectives

How well do you know yourself

In understanding your relationship with money, what are the 3 most important personal factors to consider?

These are:
  1. how long or short a time you have to invest
  2. how much risk you can tolerate, and,
  3. your investment objectives and whether they fit in with your time horizon and risk appetite.
Cash flow is another important factor to keep in mind when you assess your personal situation.  You need to have a good idea of your cash inflows and outflows and of how to do a balancing act between the two.  That is why a cash-flow needs analysis is such an important part of any financial advice programme.

By knowing more about yourself and where you want to be, you can now use this knowledge to construct an investment portfolio that fits your unique needs: 
  • your time horizon,
  • your risk tolerance and
  • investment objectives. 
In short, you have created an investment portfolio tailor-made, so that your money can work for you.


Related:
Understand what money means to you:  Answer 10 simple questions
http://spreadsheets.google.com/pub?key=tr9oMvjAsDJvkcPgXdd763A&output=html

Asset Allocation:  The Best Way to Minimize Risk of Your Portfolio
http://myinvestingnotes.blogspot.com/2011/01/asset-allocation-best-way-to-minimize.html

Saturday 12 September 2009

Risk Tolerance: Mood, Recent Events Can Change Your Point of View

What’s Your Tolerance for Risk?
Mood, Recent Events Can Change Your Point of View

by Alexandra Armstrong CFP, CCPS and Karen Preysnar CFP
8.4.2009


The dictionary defines risk as “the possibility of suffering harm or loss; danger.” But many people think of risk as the possibility of making money more than the potential of losing it. Or at least they did before experiencing the market of 2008. We’re willing to bet that you’d answer the question of how much risk you’re willing to take differently today than you would have in December 2007 when the current recession started.


The losses we saw in the stock market in 2008 as measured by the Standard & Poor’s 500 index1 surpassed previous annual losses since 1825 with the exception of 1931, reports Value Square Asset Management and Yale University. Last year’s losses weren’t confined to stocks, since corporate bonds lost value as well. Recently a money manager told us that in October, if you wanted to sell a bond position, it was difficult to find a buyer at any price. If you were invested during the last quarter of 2008, there was no place to hide — except in cash or U.S. Treasury securities.

The whole issue of risk is a difficult one to discuss. Unlike measuring height or weight, there’s no unit of measurement for risk tolerance. Your risk tolerance can be measured only relative to others on a constructed scale in much the same way an IQ is measured. Even the meaning of the word risk can depend on the situation. When individuals talk about risk as they experience it in their financial affairs, they aren’t talking about the same thing as investment researchers discussing the risk of a particular kind of investment.

As we mentioned in our November 2008 article, we provide our clients with a risk tolerance questionnaire with 20 questions. But this only gives us an idea of what degree of risk people are willing to take at the time they’re completing the questionnaire.

We have to recognize that your risk tolerance changes and can be easily influenced by recent information and even your moods. It’s easy to rate yourself as an aggressive risk-taker when you think home values and stock prices can only go up. When they come crashing down again, though, people tend to become very conservative very fast.

We think there are two basic ways of looking at risk-taking. The first is to assess the amount of financial risk you can afford to take. The second is to assess the amount of emotional risk you’re willing to take.

When assessing the level of financial risk you can afford to take, consider your age as well as the amount of assets you have. For instance, if you’re relatively young and part of a two-earner couple who don’t spend all your income, you should be able to afford to take more risk with your investments because you have time on your side. Even if your investments don’t work out as you hoped, you can make other investments in the future.

Those who are retired and need to live on the income from their investments, however, can’t afford to take as much risk. With retirees living longer than they did in previous generations, this has become more of an issue, particularly for those who don’t have a pension providing them with regular income.

The size of your total assets influences your attitude toward risk as well. People who have more assets than needed to maintain their lifestyle usually are willing to take more risk with at least some of their investments.

During the tech debacle of 2000-2002, values of homes were increasing. Assuming you hadn’t invested all your portfolio in tech stocks, even though the stock market was down as measured by the major indexes, you didn’t feel as poor because your house was worth more. Thus, you could tolerate riding out the down market of 2000-2002.

Between 2003 and 2007, your patience was rewarded, and hopefully you saw your investments grow in value. At the same time, the value of your home continued to go up. In some cases, during this period some retirees became complacent and withdrew more than the recommended 5 percent from their portfolios because they could do so. After all, they reassured themselves that their principal was intact. This past year’s market decline has changed all that. Now investors realize that markets really do go down as well as up and their investments can decline in value.

Once you’ve figured out how much financial risk you can afford to take, you need to measure your emotional attitude toward risk-taking. If your parents or grandparents lost all their money in 1929, or if your father wasn’t good at managing money, you may have difficulty taking risk with your own money. This is a very human reaction. It’s important to realize that these negative family experiences can have a lasting negative effect on your attitudes.

In addition, your attitude toward taking risk can vary over time based on your most recent experiences (either positive or negative) when you took risks. For example, some new clients will say they’re highly risk-averse, but when we examine their portfolios, they own some speculative investments. When we ask about this apparent inconsistency, they usually reply that they used to be risk-takers, but these investments didn’t work out well, so now they’re less willing to take risk. Obviously, the reverse can be true. If your experiences with taking risks were rewarded in the past, you’ll probably be more willing to take chances in the future.

After you’ve assessed how much risk you can afford to take and how much risk you’re comfortable taking, you should focus on risk reduction techniques. It’s important to start with the basic premise that it’s virtually impossible to avoid risk altogether. For instance, when you cross the street, you run the risk of being hit by a car. But there are ways you can reduce your risk. If you cross the street at a marked intersection when the light clearly indicates it’s safe for you to walk, you’ve greatly lessened your risk of being hit. If instead you’re jaywalking, you’re taking more risk.

When investing, the first way to control the negative impact of risk-taking to some extent is by doing your homework. There’s a difference between taking educated risks and speculating. Speculating is equivalent to racetrack betting if you put all your money on one horse with the name you like or the color of silks you prefer.

As a BetterInvesting member, you’re familiar with this concept of educating yourself. A company might have a wonderful product, but you need to check out its competition, the amount of debt the company has, its record of earnings and the relationship of earnings to the stock’s current price before deciding to invest in it.

We believe you can also reduce the risk you take with investments by diversifying your portfolio among different kinds of investments (international/U.S. stocks, bonds, cash) and within asset categories (small-cap, large-cap and so on). If you diversify, one investment might not work out as well as expected, but others may do well so that overall your total portfolio is worth more than the amount you invested.

For example, let’s compare two investors. Mary invests $100,000 that earns 8 percent annually. At the end of 20 years, her portfolio is worth $466,096. On the other hand, Jane invests her $100,000 among five different investments — $20,000 each. After 20 years she assesses her situation. The first investment is a total loss, while she gets her money back with the second. With the third investment, she received an average annual return of 5 percent; the fourth, 10 percent; and the fifth, 15 percent. At the end of 20 years, she would have $534,947 — almost $100,000 more than Mary does (see table, below).



Another way you can control your risk is to work with an experienced financial adviser. Although this isn’t necessarily a panacea, the adviser can show you different investment alternatives and explain both the risk and return potential of each choice. That way you can construct a portfolio that matches your risk tolerance.

We explain to clients that there’s no right or wrong attitude toward risk. What’s important is that you’re honest with both yourself and your adviser about your risk tolerance and construct your investment portfolio accordingly.

Rank your own risk temperament on a scale of 1 (risk-averse) to 10 (willing to take a high degree of risk) and then make sure you communicate this information to your adviser. If you’re married, are you more or less of a risk-taker than your spouse? We’ve often seen instances in which one spouse is willing to take a lot of risk and the other is willing to take few risks. This can lead to family conflict. You need to discuss this issue with each other, and some compromises may have to be made. For instance, the spouse who’s more willing to take risk might invest part of her portfolio in more aggressive investments than her partner.

After experiencing the 2008 stock market, many investors are shellshocked and may vow to avoid investing altogether, thus trying to avoid taking any risk. We don’t think this is a wise decision. Although this past year’s experience has been very difficult for everyone, it may have some good long-term results. Perhaps people will realize that you can’t make fortunes overnight, that you should avoid being heavily in debt, that you shouldn’t spend all your income, that it’s important to accumulate a cash reserve for a rainy day and that you really need to investigate before you invest. In other words, they may start believing all those maxims that financial planners have been preaching for years!

Although taking some risk is essential to making money, it has been our experience that you don’t have to be a speculator to build wealth successfully. We advocate controlling the amount of risk you take through self-education, portfolio diversification and consultation with a good adviser.

Having been in the investment business for over 40 years, we really believe that ultimately the pendulum will turn and selecting and holding good-quality investments will reward patient investors. We encourage you to take a deep breath, take educated risks and make sound decisions that aren’t based on emotions.

Keep in mind the tortoise and hare race. We believe the slow, steady, consistent approach works every time.

1 The S&P 500 index is an unmanaged index comprising widely held securities considered to be representative of the stock market in general. Performances of the indexes are not indicative of any particular investment. Individuals cannot invest directly in any index. Past performance is no guarantee of future results.

2 Diversification doesn’t guarantee against loss. It’s a method used to manage risk.



Alexandra Armstrong is co-author of the fourth edition of On Your Own: A Widow’s Passage to Emotional and Financial Well-Being. She is a Certified Financial Planner practitioner and chairman of Armstrong, Fleming & Moore, Inc., a registered investment advisory firm in Washington, D.C. Securities are offered through Common-wealth Financial Network, member FINRA/SIPC. Investment advisory services are offered through Armstrong, Fleming & Moore, Inc., an SEC-registered investment adviser not affiliated with Commonwealth Financial Network.

Karen Preysnar, Certified Financial Plan-ner practitioner, co-author of this article, is vice president in charge of financial planning at Armstrong, Fleming & Moore, Inc., and a registered representative with Common-wealth Financial Network.

Individuals should contact a financial planner, tax adviser or attorney when considering these issues. Commonwealth Financial Network does not give tax or legal advice. Consult your personal adviser before making any decisions. The authors cannot answer individual inquiries, but they welcome suggestions for article topics.


http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/0509fppublic.htm

Sunday 1 March 2009

Your financial advisers: Rules for the New Reality

Rules for the New Reality
by Ron LieberThursday, February 26, 2009
provided by
Back in September, before we were all inured to the tottering nature of so many financial giants, investors were looking for someone to blame.

More from NYT.com:How About a Stimulus for Financial Advice? Coaches for a Game of MoneyReaders Weigh in With Tips on Jobs and Money

So when Prince & Associates, a market research firm in Redding, Conn., polled people with more than $1 million in investable assets, it wasn’t any great surprise that 81 percent intended to take money out of the hands of their financial advisers. Nearly half planned to tell peers to avoid them, while 86 percent were going to recommend steering clear of their firms.

In January, Prince took another poll of people with similar assets, and only a percentage in the teens had engaged in trash-talking. Just under half of the investors had taken money away from their advisers.

All of the bad feelings, however, raised a simple question that’s even more essential when we’ve all been so severely tested. What, exactly, does your wealth manager owe you? And what can you never reasonably expect?

Some of the answers are basic. Your financial advisers should have impeccable credentials. They should be free of black marks on their regulatory or disciplinary records. They should agree, on Day 1, to act solely in your best interest, not theirs or those of any company that might toss them a commission.

More from Yahoo! Finance: • Why Index Funds Are Still Winners5 New Investing Rules for RetirementThe $38 Billion Shadow Stimulus
Visit the Retirement Center

But other standards are less obvious, and the carnage in the markets provides an excellent opportunity to review them.

What You Should Expect

A Long Look at Risk

Most of us aren’t honest with ourselves about how much investment risk we can handle. Even worse, we tend to change our minds at market tops and bottoms, making the wrong choices at precisely the wrong moments.

An accurate assessment of risk is important. But you can view risk in many ways.

David B. Jacobs of Pathfinder Financial Services in Kailua, Hawaii, usually starts with risk capacity. Young people have a great deal of risk capacity, since they have their whole career ahead of them to make up for any mistakes. A football player might have much less risk capacity, since he could have only a few years of high earnings. And some retirees have plenty of risk capacity, if they have a solid pension.

Then Mr. Jacobs moves to risk need. Need is driven by goals. Someone with no heirs and $20 million in municipal bonds might not care so much about significantly growing the portfolio. But if that person suddenly becomes passionate about a cause, he or she may want to double that amount in a decade to create an endowment or put up a building.

Only then does risk tolerance become a factor. “You have to help people visualize what the risk means,” Mr. Jacobs said. “If a year from now, your $1 million is $700,000, how would it change your life? Does that mean you can’t go visit your grandchildren? I’m trying to dig down and make people think of exactly what their day would be like.”

A Balance Sheet Audit

Diversifying the risks in your portfolio is merely the beginning of the process. Burt Hutchinson, of Fischer & Hutchinson Wealth Advisors in Bear, Del., trained as an accountant before earning his certified financial planner designation. He believes in tax diversification too, across a range of savings vehicles with different tax rules.

He wants his firm to act as a sort of personal chief financial officer, looking at liabilities as well as assets and at spending as much as saving. “How are you tracking your cash flow?” he will ask. “Is it increasing? Decreasing? Do you have any idea where it’s going?” He says that a good financial planner should ask to see your tax return, not just your investment portfolio.

Customization

A 100-page financial plan lands with a thud and comes with fancy leather binding. What you might not know, however, is that off-the-shelf software probably produced most of it.

More from NYT.com:How About a Stimulus for Financial Advice? Coaches for a Game of MoneyReaders Weigh in With Tips on Jobs and Money

Not that there’s anything wrong with computer projections. But most people’s financial lives, even those of the wealthy, do not contain 100 pages of complications. And enormous financial plans can be overwhelming and difficult to follow.

“Plans need not be over 10 to 15 pages,” said Timothy J. Maurer of the Financial Consulate in Hunt Valley, Md. “But every bit of it should be customized.”

To eat the same dog food

When Dr. Marc Reichel, an anesthesiologist from Beaufort, S.C., grew tired of stockbrokers pitching investments they would never use themselves, he queried a new adviser about her own portfolio. “Unlike with my previous experiences, she said, ‘Sure, this is what I have, take a look,’ ” he said. “And it wasn’t just a one-time thing. It was ongoing.”

Dr. Reichel has been with that planner, Sheila M. Chesney, of Chesney & Company in Sheldon, S.C., for nearly a decade. “The only way I could feel like I did a good job was to say that I’m doing the same thing,” she said. “If it wasn’t working for me, I wouldn’t be doing it.”
Boredom

You have the right to be bored by your financial life. There is no shame in putting things on autopilot, saving the same percentage of your income in a diverse collection of index funds for decades on end.

This philosophy drew skepticism in the 1990s for Spencer D. Sherman, when his clients wondered why he wasn’t putting them in individual technology stocks. But Mr. Sherman, a financial planner and the author of “The Cure for Money Madness,” thinks his clients would be better off seeking thrills far away from the financial markets.

More from Yahoo! Finance: • Why Index Funds Are Still Winners5 New Investing Rules for RetirementThe $38 Billion Shadow Stimulus
Visit the Retirement Center

“If you’re in a diversified passive portfolio, you have nothing to talk about at a cocktail party,” he said. “But why don’t people make investments a smaller part of their lives? It almost seems like people need to fulfill that desire for excitement somehow, and investing is an easy way to do it.”

What You Should Not Expect

Market Timing

It would’ve been nice if every wealth manager had moved clients to 100 percent cash positions around the middle of last year. The truly prescient might have put some money down on exchange traded funds that bet on the decline of various stock indexes.

But those who did probably didn’t call the top in 2000, or get back into the market in early 2003. Nor will they know when the current bear market will end. For the same reasons that most mutual fund managers consistently underperform market indexes over the long haul, especially after taxes and fees, your adviser is not clairvoyant, either.

“In the 1990s, a lot of people wanted to know how much we were going to beat the market by and our strategy for market timing,” said Laura H. Mattia, wealth management principal with Baron Financial Group in Fair Lawn, N.J. Most people know better now, after riding the roller coaster for a decade or watching the unraveling in recent months.

Low Risk, High Return

After market timing, Ms. Mattia said, this fiction is the second of two great false beliefs in money management. “It’s the same as wanting to believe in a magic pill that will cause you to lose 20 pounds,” she said. “People are looking for the easy way of achieving their goals, but things just aren’t always necessarily so easy.”

The notion seemed abstract until December. Then, after years of smooth supposed returns, prosecutors accused the wizard Bernard L. Madoff of making it all up. Recently, the Texas financier Robert Allen Stanford came under scrutiny for peddling high-yielding C.D.’s that may have been too good to be true. Anyone who utters the phrase “low risk, high return” deserves close examination.

To Be a Pest

Remember that you hire advisers in order to set some clear, long-term goals — which probably shouldn’t change every day in reaction to the ups and downs of the markets.

“One of my biggest roles is to take the emotion out and be a calming force,” said Lon Jefferies of Net Worth Advisory Group in Midvale, Utah. “If clients want to continually change their risk tolerance when the market drops another 300 points, that’s going to make it impossible for the relationship to succeed, because they’re changing the rules almost every day.”

Rather than calling every day to second-guess yourself and your adviser, set aside dates to sit down and examine your feelings.

Certainty

This one may be the toughest to swallow. Jay Hutchins, of Comprehensive Planning Associates in Lebanon, N.H., never promises an outcome. The past year, he said, should make it easier for new clients to understand why.

Even a collection of Treasury bills and top-rated, immediate fixed annuities is not enough to establish certainty in his mind. “When you decide you’re going to build a house, you build the building accordingly and with prudence, depending on whether tornadoes or earthquakes are most likely to threaten it,” he said. “Then, an airplane flies into it. Did you do anything wrong to fail to plan for an airplane crash? Of course not. You plan for what is going to be most likely.”

While Mr. Hutchins is not yet ready to predict a return to the 1930s, he doesn’t believe it makes sense to place the likelihood of it happening at zero either.

Life, in general, is unpredictable.

And for the adviser, that uncertainty should be cause for some modesty.

Milo M. Benningfield, of Benningfield Financial Advisors in San Francisco, notes that we tend to value aggressiveness. “But when I think about the meltdown, I feel like it was overconfidence,” he said. “It was a colossal lack of modesty that led people to underestimate the risk involved and believe that they understood things more than they did.”

So to him, a big part of being modest is recognizing your own limits. “You’re more inclined to say, What if I’m wrong?” he said, adding that he often reaches out for help on insurance and estate planning matters. “I think the definition of incompetence is failing to recognize that you don’t know something.”

http://finance.yahoo.com/retirement/article/106652/Rules-for-the-New-Reality;_ylt=AgyVt.WIeqvSeWfCieaON9tO7sMF

Are You Taking Too Much (or Too Little) Risk?

Are You Taking Too Much (or Too Little) Risk?
by Christine Benz
Friday, February 27, 2009
provided by

Assessing a client's risk tolerance--an individual's own assessment of his or her ability to withstand investment losses--is standard practice in the financial-planning world. The Web is full of tools to help investors gauge how they would respond if the market dropped 10%, 20%, or even 50%, and I often hear from readers who tell me that their risk tolerance is "high" or "low."

The basic premise behind getting investors to identify their pain thresholds makes sense. After all, reams of data, including Morningstar Investor Returns, show that investors often buy high and sell low. By identifying their ability to handle losses and avoiding those investments that will cause them to sell at the wrong time, investors should be able to improve their overall return records.

Yet relying disproportionately on your risk tolerance to shape your investments carries its own big risk: namely, that you'll end up with a portfolio that doesn't help you reach your goals because you've been too aggressive or too timid. Instead, risk tolerance should take a back seat to the really important considerations, such as the size of your current nest egg, your savings rate, the years you have until retirement, and the number of years you expect to be retired. Only after you've developed a portfolio plan based on those factors should you consider making adjustments around the margins to suit your risk tolerance.


The Risk of Being Too Aggressive ...

Generally speaking, I'm happy to hear from investors who rate their risk tolerance as "high." These folks' long-term mind-sets allow them to tune out the market's inevitable day-to-day gyrations and weather big losses from time to time--characteristics that usually go hand in hand with profitable investing.

Yet being too aggressive isn't always a good thing. For one thing, it's possible that you're misreading your own risk tolerance and won't behave as you think you will if and when your investments lose money. Studies from the field of behavioral finance indicate that investors' confidence level--and in turn their perceived ability to handle risk--ebbs and flows with the market's direction. Thus, an investor might rate highly his own ability to handle risk at the very worst time--when the market is skyrocketing and stock valuations are high--only to exhibit much less confidence in the event of a market drop. (Not surprisingly, buoyant markets are also when most financial-services firms hawk the riskiest products.)

Moreover, being loss-averse has a foundation in simple math. After all, the stock that drops from $60 to $45 has lost 25% of its value, but it will have to gain 33% to get back to $60. The same cruel math holds for the whole of your portfolio, so it's no wonder that investors are inclined to rate themselves as risk-averse; losses are tough to recover from.

Big losses can be particularly painful for those who are getting close to retirement, because their portfolios have less time to recover from the hit. If you're 30 and your 401(k) balance goes down by 37%--as the S&P 500 did last year--it's a painful but not cataclysmic blow. After all, you might have 30 years or more to recoup those losses, and depressed stock valuations give you the opportunity to buy stocks on the cheap.

By contrast, if you're in your mid-60s and saw your retirement-plan balance shrink from $800,000 to little more than $500,000 over the past year, you don't have as many options. You could continue working to amass more savings or dramatically scale back your planned standard of living in retirement, neither of which is particularly appealing. The bottom line is that there are real reasons to grow more protective of your nest egg as you grow closer to needing your money, and there are real risks to letting your own assessment of your risk tolerance guide your asset-allocation decisions.

... Or Too Conservative

However, with the market dropping sharply over the past year, I'd wager that being too conservative is a bigger risk for many investors right now than is maintaining a portfolio that's too aggressive. Just as investor confidence improves as stocks march upward, so does pessimism take over when stocks are in the dumps.

Yet anyone tempted to make his portfolio more conservative should ponder a real risk of that tactic. By avoiding stocks and sticking exclusively with "safe," fixed-rate securities such as CDs or short-term Treasuries, you also put a cap on your portfolio's upside potential, which in turn heightens the risk of a shortfall come retirement. True, stocks have greater loss potential than do short-term fixed-income investments, but they also have the potential for greater gains. Moreover, the gains from short-term, high-quality investments are pretty darn skimpy right now: You're lucky to earn 3% on a one-year CD.

That might not sound terrible. After all, the S&P 500 Index has lost about 3%, on an annualized basis. Yet while inflation is currently minimal right now, it won't always be so benign. In fact, inflation has the potential to gobble up most, if not all, of the return you earn from any fixed-rate investment. The upshot? For retirees, pre-retirees, and 20-somethings alike, hunkering down in safe, fixed-rate investments is a luxury you probably can't afford, even if it helps you sleep at night. To help offset the effects of inflation, you need to have at least part of your portfolio in stocks, whose returns have the potential to outstrip inflation over time.

Just Right

So if it's a bad idea to let your gut guide your stock/bond mix, what should you do? Your key mission is to let hard numbers--rather than your own comfort level--be the chief determinant of your asset-allocation plan. Employ an online asset-allocation tool, such as Morningstar's Asset Allocator, to help you optimize your asset allocation based on your goals, your savings rate, and the number of years you have until retirement. Alternatively, you could hire a financial advisor for even more customized help or look to the asset allocations of target-maturity funds for back-of-the-envelope guidance. (David Kathman discussed how to do that in a recent The Short Answer column.)

Once you've put your basic asset-allocation framework in place, it's fine to make some adjustments around the margins based on your own comfort level. For example, if you determine that you should have the majority of assets in equities, you could focus on underpriced large-cap stocks or invest with a stock-fund manager who places a premium on limiting losses. On the bond side, you could limit your portfolio's risk level by going light on more-volatile asset classes like high-yield bonds and sticking with high-quality short- and intermediate-term bonds.

Beyond these small adjustments, it's a big mistake to let your emotions--and that's essentially what irrational risk aversion is--drive your portfolio planning. If the market's ups and downs leave you with excess nervous energy to burn, focus on factors you can actually influence, such as improving your security selection and lowering your overall investment-related and tax costs.

http://finance.yahoo.com/retirement/article/106656/Are-You-Taking-Too-Much-or-Too-Little-Risk;_ylt=AgJi2m23enNuwutOjND70J5O7sMF?