Rule No. 1: Don’t Panic!
Financial planners tell stories about people who hesitate to invest in the stock market because they fear risk. There are widows who fear that a stock crash could leave them destitute. There are young couples who pine for a new home but worry that an investment loss could kill their chances. And there are people who remember parents who were devastated by the 1929 market crash and simply don’t want it to happen to them.
Often, however, these fears are rooted in a misunderstanding of what risk is when it comes to the financial markets. Those who understand market risks--and properly evaluate their ability to tolerate them--can supercharge their investment portfolios by embracing a certain amount of uncertainty.
James P. King, a financial planner from Walnut Creek, Calif., illustrates the point with a riddle: Consider two investments. With the first, you are guaranteed to lose money. Invest $1,000, you’ll lose $1,000. The other could allow you to cash out with an amount ranging from $0 to $5,000 on your $1,000 investment. Which is riskier?
Many individuals would say the riskier investment is the first, because their principal would be in greater jeopardy. But to financial professionals, the first investment is merely stupid--not risky--because it’s a sure thing to lose.
In the financial world, risk translates to uncertainty. “It’s measured by standard deviation from the norm,” says James E. Andelman, consultant at Ibbotson Associates, a Chicago-based market research and consulting firm.
“Most individuals measure risk as their chance of loss,” King says, “but we measure risk by the variability of returns.”
In a market that hangs its hat on the close correlation between risk and reward, that’s an important distinction. Stocks are considered risky because their prices deviate, sometimes by a lot. In the stock market’s worst year, the value of big-company shares fell 43.3%. In its best year, they rose 53.9%. But even as prices swing wildly, the odds are in your favor over the long haul.
Nothing illustrates the point better than charts compiled by Ibbotson that show the variability of returns--and total returns--from 1926 through 1995. The summary version: The returns on small-company stocks--which are even more volatile than big-company stocks--have varied by as much as 78% in a given decade, whereas the returns on Treasury bills have varied by less than 1%. But because the Treasury bill returns are a relative sure thing--there’s very little deviation--the rewards are slim.
Consider: If you had invested $1 in the U.S. stock market in 1926 and left it there until 1995, you would have suffered some sickening jolts--including the 1929 market crash and the 1987 mini-crash--along the way. In fact, big-company stocks lost value in 20 years out of 70, according to Ibbotson. But you also would have enjoyed some years in which your wealth soared. In the end, your $1 would have grown to a stunning $1,114.
If, on the other hand, you had invested that $1 in Treasury bills in 1926, you would have seen only one down year, and the loss would be too small to mention. In all 69 others, your return would have clicked ahead steadily.
Still, because your average annual return would amount to a lackluster 3.7%, your $1 would have been worth just $12.87 at the end of 1995.
And if you factor in inflation and income taxes, the effect on your buying power of investing in T-bills begins to look a great deal like the first answer in King’s riddle.
Still, what worries many is that you never know when the stock market is going to dive. What if it falls right before you need to sell?
If you had left your money invested for at least several years, chances are you’d still be ahead.
Let’s say, for example, that you earn 10.5% annually for five years on a $1,000 stock investment. But on the day you need to cash out, the market dives and your portfolio loses 20% of its value. You’d still cash out with $1,349.28.
What would have happened had you put $1,000 in a 5% certificate of deposit and never suffered a loss? You would cash out with $1,283.36 after five years.
In other words, because stocks have higher average returns, you can suffer some losses and still end up vastly ahead over the long run.
There’s only one situation in which adding stocks to your portfolio doesn’t make sense--when you don’t have time to let the market work for you.
In any given year, you have about a 1 in 4 chance of taking a loss in the stock market. If one year or less is as long as you plan to invest, stocks boil down to a gamble.
But if your time horizon is five years or more, there’s a very good chance that putting at least a portion of your money in stocks will boost the performance of your entire portfolio.
To help assess how much risk you can handle, take the risk quiz on this page. That, along with assessing your overall financial goals and how much time you have to achieve them, will help you determine the diversification needed for your portfolio.
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How Much Are You Willing to Risk?
How much investment risk can you tolerate? Take this quiz to find out.
Even if you have not experienced a specific situation in the quiz, try to answer based on what you think you’d do if you faced the issue today. The quiz should be used as a tool for self-evaluation, not as a basis for making specific investment decisions.
1. My salary and overall earnings will probably grow significantly in coming years.
a) disagree strongly
b) disagree
c) neither agree nor disagree
d) agree
e) agree strongly
2. If I were deciding how to invest contributions in my retirement plan, I would choose investments that offered fixed yields and stability.
a) agree strongly
b) agree
c) neither agree nor disagree
d) disagree
e) disagree strongly
3. I believe that investing in today’s volatile stock market is like spinning a roulette wheel in Las Vegas--the odds are against you.
a) agree strongly
b) agree
c) neither agree nor disagree
d) disagree
e) disagree strongly
4. If I were picking a stock to invest in, I would look for companies that are involved in developing the hot products of the future, such as the next penicillin.
a) disagree strongly
b) disagree
c) neither agree nor disagree
d) agree
e) agree strongly
5. If I were selecting an investment for my child’s college education fund, I would choose:
a) certificate of deposit
b) government-backed mortgage securities or municipal bonds
c) corporate bonds
d) stocks or equity mutual funds
e) commodities futures contracts
6. The following number of dependents rely on me for their financial welfare.
a) four or more
b) three
c) two
d) one
e) I have no dependents
7. The number of years remaining until I expect to retire is about:
a) currently retired
b) less than five years
c) five to 14 years
d) 15 to 24 years
e) 25 or more
8. My net worth (the value of my assets less my debts) is:
a) under $15,000
b) $15,001-$50,000
c) $50,001-$150,000
d) $150,001-$350,000
e) more than $350,000
9. The amount I have saved to handle an emergency, such as a job loss or unexpected medical expenses equates to:
a) one month’s salary or less
b) two to six months’ salary
c) seven months’ to one year’s salary
d) one to two years’ salary
e) more than two years’ salary
10. I would rather invest in a stock mutual fund than buy individual stocks because a mutual fund provides professional management and diversification.
a) agree strongly
b) agree
c) neither agree nor disagree
d) disagree
e) disagree strongly
11. I want and need to reduce the overall level of debt in my personal finances.
a) agree strongly
b) agree
c) neither agree nor disagree
d) disagree
e) disagree strongly
12. When making investments, I am willing to settle for a lower yield if it is guaranteed, as opposed to higher yields that are less certain.
a) strongly agree
b) agree
c) neither agree nor disagree
d) disagree
e) strongly disagree
Scoring: Give yourself one point for every ‘a’ answer, two points for every ‘b,’ three for every ‘c,’ four for ‘d’ and five for ‘e.’
46 and higher: You probably have the money and the inclination to take risks. High-risk investments include aggressive-growth stocks, start-up companies, commodities, junk bonds and limited partnerships, as well as stock options and investment real estate. But be sure to diversify at least some of your portfolio into safer investments. You could regret your high-risk tolerance if you lost everything.
41-45: You have an above-average tolerance for risk and probably enough time and income to cover your losses. Investors in this category are wise to mix high-risk and low-risk options.
36-40: You have an average tolerance for risk but don’t like to gamble. Consider a mix of long-term investments that have a history of strong and steady performance. Blue-chip stocks, high-grade corporate bonds, mutual funds and real estate may all be options.
31-35: You have below-average tolerance for risk, either because of your age or your income and family circumstances. Comfortable investments for you would probably include your home, high-quality bonds, government-backed securities and federally insured savings accounts.
30 and below: You have virtually no tolerance for risk. Look for investments that have government backing, such as bank and thrift certificates of deposit, Treasury bills, bonds and notes.
Source: Fidelity Investments, 1991. Developed in association with Andrew Comrey, professor of psychology, UCLA
