When clients tell us that they're worried about risk, what, exactly, are they talking about? Well, if they were watching television during the dot-com bust, they probably saw some people who not only lost their entire investment, but also lost their homes. As advisors, we understand risk, but more importantly, we need to understand what our clients think risk is, and to be able to categorize the different kinds of risk for them in a way that is easy to grasp. It is up to us, as professional wealth managers, to understand the risk that our clients are talking about and to explain the range of risks to them clearly.
Consider unsophisticated investors, for example, who saw traders making money and figured they could day-trade, too. They bought very high-risk stocks on margin without understanding that if the stock declined dramatically, the entire loss would be theirs. Many of these investors actually believed that all of the gains were theirs, but if there were big losses, they would only lose up to their investment; the margin provider would lose the rest.
When clients speak of risk, they almost always mean short-term volatility. They want to know if they can lose much, if not all of their money, in a week, month or a year. They rarely consider the risk of not having enough money to retire however many years from now, or the risk of inflation eating away at the value of their money.
Sometimes, the simplest explanation is really the best. I advise my clients that losing all of their money in any one investment is the equivalent of getting hit by lightning--a very rare occurrence.
If you have a well-diversified portfolio, the chance of losing all of your money is like getting hit by lightning over and over and over again--not much chance of that happening!
Explain to your clients that since 1926, there have been only 22 years when the stock market has posted a loss. The worst year of all was 1931, when the market crashed, declining more than 40 percent. For most high-risk investors, the recent dot-com bust was their "crash."
You have undoubtedly seen the statistic that the average rate of return on stocks was about 10 percent over the past 60 or 70 years. During that same period, the average annual return of short-term U.S. Treasury bills, which roughly equals the return on savings accounts, was slightly under 4 percent, and the annual return of long-term government bonds was just over 5 percent.
Statistically, if you hold an investment-grade common stock for only one year, you have a 70 percent chance of making a profit. If that time frame is increased to 5 years, the odds of making a profit go up to 88 percent. A 10-year holding period promises a 96 percent chance of profit; and in 15 years, the theoretical probability of making a profit shoots up to 100 percent.
That being the case, why wouldn't everyone be 100 percent invested in stocks at all times?
The answer is that while stocks have done well over the long term, there have been many short-term periods during which an investor would have lost money.
When it comes to investing, experience is the best way to learn how much risk a person is willing to take. Risk tolerance will always be influenced by a person's circumstances--age, goals, needs and means.
Financial risk can be divided into two parts. The first is the probability of the stock declining. The second part is the potential magnitude of the decline. It's the lightning analogy again. It may be incredibly rare to get hit by lightning, but if you are hit, the consequence is devastating. (While there are numerous categories of risk, we are dealing here with financial risk only--not opportunity risk such as investing in real estate or art, nor any type of dishonestactivity by an advisor.
Among these financial risks is risk that affects a specific company. For example, it might be discovered that one of its products causes cancer, or that new government regulations hurt results, or that actions by management are causing the company and its stock to go south.
If you put all your money into the stock of one company, you could experience both stock market risk and company-specific risk. Spreading the same money among a number of different stocks will dramatically reduce company-specific risk.
Diversification is the investment equivalent of not putting all your eggs in one basket. Since all of your choices won't be right--or wrong--at the same time, you reduce your risk by lowering your exposure to any one investment. The number-one rule of portfolio management is diversification. It's not sexy, but it is very important. The recent tech stock debacle proves how important diversification is.
Market risk is the risk that the entire market will go down. If you invest in a large, well-diversified portfolio or mutual fund, there is still the risk that "the market" will fall. When that happens, the value of what you own will fall, too.
The best way to reduce stock market risk is to diversify outside of the stock market. For example, buying bonds is a good way to reduce your vulnerability to a falling stock market.
One way to handle risk is to minimize or avoid it. This can be done by investing in "risk-free" investments, such as short-term United States government bonds. However, a portfolio too heavy on bonds won't protect you from the two biggest dangers--inflation and longevity. On the other hand, if you hold no bonds or cash, and you need money for other purposes, you run the risk of taking too much out of equities in a down market. Of course there is more risk associated with holding a long-term bond than short-term paper because of the uncertainty of future inflation and interest-rate levels.
And there is inflation risk--causing your rate of return to be lower than the rate of inflation over many years. If the long-range inflation rate was the same as your long-range rate of return--even though your investment decisions were right--basically, you only broke even in terms of buying power.
Finally, there's also the risk of outliving one's money. Retirees now in their 70s never factored life expectancy into their financial planning.
This, of course, has created what appears to be a three-sided coin. Since we're living much longer, we will need much more money than we anticipated needing. On the other hand, this also gives us more time to accumulate that money...at whose value the unrelenting march of inflation will continue to eat away.
Investors need to think about the time period involved in their investment plans. Generally speaking, the longer the time horizon, the more risk can be incorporated into the financial plan.
It is our job to explain to clients that planning is the most important thing they can do for their own future. Most people simply react to circumstances. The problem is that you cannot "react" your way to financial security.
Gary Wollin (www.garywollin.com) is a Warren Buffet-style investment advisor with 45-plus years of Wall Street experience. Regularly featured in The Wall Street Journal, New York Times and other publications, he writes and speaks on sales, customer loyalty and the stock market.
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