by Bryan Olson, CFA, Vice President, Head of Portfolio Consulting, Charles Schwab & Co., Inc. February 14, 2008
Because money is an emotional subject and our emotions often lead us in the wrong directions, there are few things more important than knowing yourself as an investor. And that means examining your attitude toward risk—the potential for seeing your investments lose value and how you might react in various situations.
Once you decide how much risk you are comfortable with, then you can choose the investment strategy that is right for you.
The element of risk at a glance ...
Although some investments are considered riskier than others, every investment brings with it some form of risk.
Although you can't eliminate risk, you can control the type and level of risk you're exposed to through your choice of investments and diversification.
A little caution is valuable in investing. Too much caution can stop you in your tracks and cause you to fall short of your goal. All investment plans need to include a realistic evaluation of your personal risk tolerance and risk in the markets.
You should consider two major factors as you develop your investing plan toward reaching your financial goals: your risk tolerance and your time horizon.
The different colors of risk
It would be nice if there were a way to eliminate all the risk that comes with investing. Unfortunately, that's not possible. It's true that some investments are considered riskier than others. For example, stocks are generally considered riskier than bonds.
Every investment carries some form of risk, even a savings account. Sure, you won't lose money in a bank savings account, but over time your money probably won't grow enough to beat inflation. In this case, you risk losing purchasing power.
Below are some common sources of investment risk and the strategy you can take to mitigate the risk. Take a look at the list and see which ones you are most sensitive to. Make sure your investment plan adequately addresses them.
Risk type
What it is
How to mitigate
Market risk
Exposure to an asset class's ups and downs. Investments in various asset classes experience different levels of volatility.
Diversify your portfolio among asset classes that do not move in tandem.
Security-specific risk
The risk associated with the financial health of the company issuing the security or company-specific news. A particular company’s security may fall even when securities of other related companies are up.
Select quality investments and diversify across multiple securities and issuers.
Liquidity risk
The possibility of not being able to sell an asset when you want to or being forced to sell at a lower price. Stocks and bonds tend to be more liquid than real estate, but even certain types of stocks and bonds have low trading volume and limited marketability.
Know how liquid an investment is before you invest. Make sure your portfolio has enough liquidity to meet your needs. Typically, illiquid investments should only make up a small percentage of your portfolio.
Inflation risk
The risk that your investment income and gains won't keep pace with rising inflation.
Include in your portfolio investments that protect you against rising inflation such as stocks, Treasury Inflation Protected Securities (TIPS), and real estate.
Interest rate risk
The risk of interest rate changes impacting the value of your investments. Bond prices move in opposite direction of interest rates. Long maturity bond prices fall more when interest rates rise.
Position the duration of your portfolio (i.e. the weighted average maturity of a bond’s cash flows) to match your investment horizon. Tactically shift your portfolio to shorter maturity bonds or away from bonds if you expect interest rates to rise.
Re-investment risk
The risk that you will not be able to reinvest coupon payments and principal at the same high rates the funds earned before principal payments were made. Investors requiring a certain level of cash flow per month from their investments are vulnerable when interest rates drop.
Ladder your portfolio or set up a cash management program to reserve cash from sales proceeds or portfolio rebalancing. Use a total return approach to managing your portfolio.
Timing risk
The risk that you buy just before the price peaks or sell at the bottom, or completely missing the market upturn by staying at the sideline. Greed or fear, such as in chasing hot investments or not investing new money increases this risk.
Do not attempt to time the market. Invest for the long term. Dollar-cost average your investments.
Goal shortfall
The risk of outliving your savings or not meeting your goal at the end of your investment period.
Evaluate your future needs, estimated future growth of your portfolio and progress toward your goal. Create a written investment policy statement with reasonable returns expectations and adhere to it. Make sure your risk tolerance is not overly conservative.
The degree of risk you're comfortable with—the subjective part of your risk tolerance—is one of the major factors to consider as you develop your investing plan. Although you can't eliminate risk, you can control the type and level of risk you're exposed to through the structure of your portfolio and choice of investments.
For example, if you invest in stocks, will you be pacing the hall every time the market drops 100 points? Or will you be able to withstand that fall knowing that, stocks have a greater potential for growth than other kinds of investments over the long-term? Here's a history of how much downside investors owning stocks saw during the past 38 years:
Stocks1
Any single year
Annualized 3-year period
Annualized 5-year period
Annualized 10-year period
Worst
-26.5%
-14.6%
-2.4%
5.9%
Average (1970-2007)
14.1%
13.9%
13.7%
14.1%
Number of negative periods
8/38
5/36
5/34
0/29
Recent bear markets
Cumulative period return
1/73-9/74
-42.63%
9/00-9/02
-44.73%
Source: Schwab Center for Financial Research with data provided by Morningstar, Inc. As of December 31, 2007.
Avoiding analysis paralysis A little caution can be a valuable trait. It can help you remain calm and make good decisions when everyone else is may be reacting emotionally to short term market movements. But too much caution can cause harm to your plans.
If you've had losses in the past, don't let the fear of repeating those mistakes keep you from investing. Working with a financial consultant can help you get over the hump and develop a plan to ease you into the risk level appropriate for your personality, life situation and goals.
It's about time
While risk is one major factor to consider in creating an investing plan, the other is time: how soon you'll need to use the money you're investing. Your time horizon has a direct effect on the investments you choose and the amount of risk you can comfortably take on.
Some investments, such as money market funds, might be good short-term investments. They're highly liquid and lower in risk, so it's very unlikely that you'll lose your capital. Other investments, such as stocks, are better suited for longer time frames. Stocks prices tend to fluctuate in the short term (this is called volatility), but offer potentially higher returns over the long term.
Creating your portfolio
Because different investment classes do not respond to market forces the same way, combining them together to form a “basket” or portfolio can help you achieve your investing goal more efficiently (same or higher potential reward with lower risk.) Consider Schwab’s five model portfolios—which are a mix of five asset classes of investments spanning a wide range of risk levels from conservative to aggressive.
Schwab's five model portfolios
Conservative investors tend to favor low-risk investments that have lower potential return. Aggressive investors tend to take on higher levels of risk in pursuit of potentially higher returns. Your investing style may very well fall somewhere in between. Also, your personal life situation such as cash flow and tax considerations may require a more custom evaluation with the help of an advisor.
Across the risk spectrum Source: Schwab Center for Financial Research with data provided by Morningstar, Inc. As of December 31, 2007.2
What kind of investor are you? As a start, you can discuss your risk profile with a Schwab consultant or complete Schwab's short Investor Profile Questionnaire found on Schwab.com. This seven-question questionnaire examines the timing of your cash need, your investing experience, maximum loss you can tolerate and return expectations. Your answers, which capture the essence of your risk tolerance, are used to guide you to the asset allocation that suits you best.
You should take a look at your current asset allocation, realistically evaluate your risk tolerance, and make sure the two are aligned. Having an understanding and comfort level with how your portfolio might perform will increase the likelihood of sticking with your plan through the market’s ups and downs. As your investment experience increases or your life situation changes, don’t forget to revisit your risk tolerance assessment.
Important Disclosures
1. As represented by the S&P 500 index.
2. The return figures for 1970 through 2007 are the average annual returns of the hypothetical asset allocation plans. The asset allocation plans are weighted averages of the performance of the indexes used to represent each asset class in the plans, include reinvestment of dividends, and are rebalanced annually. The indexes representing each asset class in the historical asset allocation plans are S&P 500 Index (large-cap stocks); CRSP 6-8 Index (small-cap stocks); MSCI EAFE net of taxes (international stocks); Ibbotson Intermediate U.S. Government Bond Index (bonds); and 30-day Treasury bills (cash).
Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling 800-435-4000. Please read the prospectus carefully before investing.
Investments in securities do involve risk and the value of an investment will fluctuate, so that shares, when redeemed, may be worth more or less than original cost.
An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund typically seeks to preserve the value of an investment at $1.00 per share, it is possible to lose money by investing in that type of fund.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed.
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