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How to Manage the Most Important Risks of Investing
by Paul A. Merriman Publisher and Editor
Bankers understand this flawlessly. If Bill Gates and a teenager picked at random walked into a bank on the same day, both wanting a loan, who would get the better deal? Bill, of course. The bank takes virtually no risk loaning money to the world’s richest man. But almost any teenager represents a considerably higher risk, and the bank expects to be paid a higher interest rate for making such a loan.
Bankers carefully calculate their risks; investors should do the same. Too many investors forget the link between returns and risks. If you’re seeking above-average returns through aggressive investing, you are unavoidably taking above-average risks. And if you’re seeking above-average safety, as when you invest in Treasury bills and CDs, you will unavoidably get below-average returns.
Smart investors know how much risk is appropriate for them, and they don’t exceed that level. They realize that risks come in many forms, and there is no way to totally escape them. Even if you invest in government-guaranteed certificates of deposit, you are taking a risk, as we’re about to see.
If you can recognize risks, you can manage them with relatively simple solutions. But too many investors underestimate the importance of doing this – and it’s one of the most important tasks investors should do.
In this article I’ll outline the major risks any investor takes and give you some pointers on how to manage them.
Inflation risk. This is the risk that money you save or earn will lose some of its purchasing power. Even if your five-year certificate of deposit is guaranteed, the dollars you get back may not buy as much in five years as they bought when you took them to the bank.
It may make you feel giddy to receive double-digit interest on your money-market fund, as some investors did in the early 1980s. But if inflation is also in double digits, as it was back then, you’re more likely to fall behind economically than get ahead.
From 1970 through 1999, the cost of living in the United States rose at a compound rate of 5.1 percent a year. Many people believe they will be secure if they can retire on a fixed income of $50,000 a year, which in many cases is adequate today. But at the rate of 5.1 percent inflation, after 25 years you will need $173,400 to buy what you can get today for $50,000. Even if inflation is much more modest, say 3 percent, a person who retires on $50,000 today at age 55 will require $104,700 at age 80 to buy what $50,000 buys today.
Stated another way, with inflation of 3 percent over 25 years, your $50,000 will be worth only about $23,300 in today’s dollars. At inflation of 5.1 percent, it will be worth only $13,500.
You may think these numbers are far-fetched and have a hard time relating to them. But we were amazed to read that in King County, Washington, where we’re located, per-capita income rose from $4,834 in 1969 to $40,904 in 1998.
The way to protect yourself against this risk is to own at least some equity assets. For most investors, that means stock funds. Over the past 75 years, the annual inflation-adjusted return of the Standard & Poor's 500 Index was 8 percent; for small-cap stocks it was 9 percent, while it was only 0.7 percent for Treasury bills and 1.5 percent for government bonds.
For the most timid investors, the federal government’s Ibonds (savings bonds with interest pegged to changes in the cost of living) can be a solution.
Most investors ought to have at least 10 percent of their portfolios in assets that can increase in value, such as stock funds. As we showed in a table we published last year, studies show that even a 10 percent equity stake can noticeably increase the return while at the same time it actually reduces the risk of an all-fixed-income portfolio.
Business risk. This is the risk that you buy stock in a company that fails or has a major unexpected deterioration in its business. The cure for this risk is basic and simple: diversification. If you own stock in one or a handful of companies, an unexpected disaster hitting one of them can do serious damage to your portfolio. But if you own 500 companies, a disaster in one will have little overall effect.
Credit risk. This is the variation of business risk that affects bond investors. You can buy a bond issued by a company that can’t pay the interest or the principal. It’s called a default. More commonly, the company that issued your bond has an unexpected deterioration in its business, and its bonds are downgraded by rating services. When that happens, the market value of the bond falls.
The cure for credit risk is mostly diversification. If you own a single bond and it winds up being a bummer, you may be in a heap of trouble. But if you own 200 bonds, as is typical of some bond funds, one or two duds won’t spoil your party.
Manager risk. Once you determine the proper amount of your portfolio that should be in stocks, you typically hire a manager to pick them for you. Or you buy a mutual fund, which amounts to the same thing.
You’ll probably pick a manager with a winning personality, persuasive marketing materials and a track record that’s impressive.
There’s just one problem: Very, very few people have been able to successfully pick market-beating stocks over long periods of time, and even the best track records don’t last forever.
By now you might be able to guess the recommended way to overcome this risk: by practicing the most fundamental investing technique of all, diversification.
Invest in index funds that in turn invest in hundreds or even thousands of stocks. If you prefer actively managed funds, split your investments among multiple managers. If you’re investing in an actively managed large-cap value fund, choose two of them, run by different managers. Some mutual funds give you a way to do this in a single package. Schwab, for example, has several funds called MarketManager, which invest in other mutual funds carefully chosen for their managerial prowess. It’s a way to get the benefit of several fund managers in a single package, with a single minimum initial investment requirement.
Asset risk. This is the risk that you can be invested in the wrong asset class for an extended period of time. An asset class is a category of assets such as U.S. large-cap growth stocks or precious metals stocks. Some inexperienced investors, and some who have been around long enough to know better, put most or all of their portfolios in whatever assets have been showing superior recent performance. Few young investors today realize that even asset classes that have been reliable in the past can be extremely disappointing for long periods of time.
Imagine a 55-year-old investor in 1965 who counted on decent stock market returns as he planned to retire l0 years later. From 1965 through 1974, the Standard & Poor's 500 Index compounded at an annual rate of only 1.24 percent. Diversification could have helped. In that same period, the annual gains were 2.1 percent for corporate bonds, 5.4 percent for Treasury bills, 5.5 percent for large-cap value stocks and 7.1 percent for small-cap value stocks.
The way to protect yourself from asset risk is to diversify. Identify the major asset classes available to investors, along with the historical returns and risks of each, and determine what mix is suitable for you. Our Model Portfolios and past articles like “The Best Buy-and-Hold Portfolio We Know” should give you the guidance you need.
Count on mutual funds for diversification, professional management and convenience. But count on yourself or your investment advisor for determining and implementing the best mix of asset classes.
Market risk. This is the chance that the entire market, either bonds or stocks, goes way up when you want to buy or way down when you want to sell. The market is the product of nearly countless influences and forces, both economic and psychological, both rational and irrational. In the very long term, it’s a relatively safe bet that the market will continue its upward climb. But nobody can consistently and accurately predict what the market will do in a week, a month, a year or even a decade.
Over the past century, the U.S. stock market measured by the Dow Jones Industrial Average has experienced 19 bear markets in which the index declined more than 20 percent. The table on page 4 shows those declines, technically known as drawdowns. The starting date represents a market peak; the ending date is the lowest point before the Dow began moving upward.
These figures, by the way, represent bear markets for the highest quality companies. If you think this is all in the past, remember that the Nasdaq 100 Index suffered a decline of more than 50 percent last year. And Warren Buffet's Berkshire Hathaway, a portfolio managed by one of the best in the business, dropped 50 percent from March 1999 to March 2000.
If you’re an equity investor, you have two ways to protect yourself from bear markets.
Bond investors, including those who invest through bond funds, can protect themselves by the use of market timing and by investing in short-term bonds, which are less volatile than bonds with longer maturities.
One form of market risk is paying too much for assets when you invest in them. By using dollar cost averaging, the practice of routinely investing a fixed amount in an asset every month or every quarter or every year, you automatically buy more units when prices are down and fewer when prices are up. Over time, this technique will make your average price per share of a mutual fund lower than the average of all the prices at which you bought. This is the technique many investors use when they put $2,000 into an IRA every year and when money comes out of every paycheck to go to a 401(k) or similar retirement account.
Tax risk. This is the risk, usually a certainty, that your investment gains will be diminished by income taxes. Later this year, all mutual fund prospectuses will have to disclose more fully the theoretical impact of taxes on their returns. This will make returns look smaller, because the Securities & Exchange Commission has ordered that prospectuses and advertisements assume investors are in the highest tax bracket, 39.6 percent.
There are plenty of ways to protect yourself against tax risk, but some of them come at the expense of good investing principles. Many people bought limited partnerships in the early 1980s, having been promised substantial tax write-offs from big expected losses. Then something unexpected happened: Congress changed the tax laws in 1986. The investment losses came as expected, but the tax write-offs disappeared; without tax breaks, many limited partnerships didn’t have good enough fundamentals to attract any new buyers.
Here are a few of the ways you can save taxes on your investments. Each of them works, but each has drawbacks that you should understand in advance.
Expense risk. This is the risk that your investment returns will be eroded by paying needlessly high expenses. Expenses are like anchors being dragged behind a sailboat. They may be invisible, but they inevitably reduce the speed of the boat. High expenses take many forms, including sales commissions (called loads in mutual funds) and ongoing expense ratios.
Every investment manager expects and deserves to be paid. But some investment companies and products charge investors much too much. How much is too much? This varies depending on the type of fund. But if you invest in a fund that charges you more than the category average, easily obtainable at Morningstar.com, you should have a very good reason.
The best way to control this risk is to inquire about expenses before you invest. Every investment product involves expenses; don’t invest in one until you understand this element. Here are a few specific suggestions:
Event risk. This is the risk that some unexpected event will topple the market, or part of it. This may be an assassination, a natural disaster, a political upheaval or some man-made crisis that causes investors to suddenly question the future. This risk also can be very personal, affecting only you and your family: a death, illness, layoff or a house fire.
Unless you keep all your money in government-guaranteed bank accounts, there is no absolute protection against sudden events. Your best protection may be the right attitude, that life is uncertain and the uncertainty is part of what makes it worth living, backed up by an emergency fund that would let you continue living if your income were interrupted or if your expenses suddenly skyrocketed.
Liquidity risk. This is the risk that you won’t be able to get your money quickly when you need it without taking a significant investment hit. If you own a small business, selling it for anything close to what you think it’s worth is usually difficult and time consuming. If your wealth is tied up in raw land and you need to turn it into cash, you may have to wait months or years to get the price you think you deserve. If you invest in limited partnerships and need to sell before they expire, you may have to sell at a substantial loss.
You protect against this risk two ways: First, by making sure that most of your investments are in liquid assets that can be sold quickly and inexpensively; stocks, bonds and mutual funds all qualify. Second, by having an emergency fund that will let you quickly get your hands on money when you need it, without having to sell an investment you had planned to keep.
Fraud risk. This is the risk that you’ll simply be defrauded in your investments. This is different from making a dumb mistake. Fraud deliberately creates victims. To keep yourself from becoming one of them, deal with reputable investment professionals. Don’t make impulsive decisions about unfamiliar investments; instead, take the time to have somebody thoroughly check out anything you are considering.
If you’re told you must make a decision immediately to take advantage of a deal, there is only one right answer: “I’ll pass.” If you are offered something promising an unusually high return, remember that risks and returns always go together; if you can’t identify the risks you are taking in order to seek a high return, leave your checkbook in the drawer where it belongs.
Finally, follow one of the most basic of all investment rules: Don’t invest in something you don’t understand.
Emotional risk. This is the risk that your emotions will get out of hand and start dictating your decisions. Greed and fear are the two biggest forces driving Wall Street, and nobody is totally immune to them. Another form of emotional risk is grandiosity, thinking you know more than you really do and becoming overconfident in your ability to see into the future.
We sometimes see emotional risk most clearly when investors who are on the sidelines see others making big gains, and eventually they get so anxious to get some of those gains for themselves that they just jump into whatever is “hot” in the market. We call this the “I can’t stand it any more” market timing system, and very often it leads people to buy at close to the peak of a market cycle. We see the converse of this when investors get increasingly frustrated and exasperated at continuing losses, and finally they “can’t stand it any more” and sell, often at close to the bottom of a market cycle.
If investors could follow the old Wall Street saying, “Buy low and sell high,” they would make money. But in both instances, the “I can’t stand it anymore” timing system leads them to do the opposite.
To protect yourself from the risk of grandiosity, be brutally honest about the results of the investments you have made. Keep a list, if necessary, of the decisions you made that went wrong. Next time you are sure that you know better than the rest of the market, pull out the list and study it.
The best protection against emotional risk is a disciplined plan for buying and selling. Make sure your assets are balanced so you can sleep at night no matter what the market is doing. If you use market timing, follow a strict discipline, preferably having somebody else implement it for you – somebody without any emotional charge on each trade. If you are a buy-and-hold investor, make sure you have enough fixed income in the portfolio to moderate the volatility of equities; and make sure you have some equities in the portfolio so you won’t feel totally left out during bull markets.
Finally, the biggest risk of all: You could run out of money before you run out of life. This is the biggest fear of many retirees, that their resources won’t last long enough to support them for life.
There are several good ways to protect yourself against this risk, but none is foolproof. You must protect yourself against inflation, which we already discussed briefly. You must keep your living costs within reasonable bounds. You must start with enough assets before you stop working. Every year “early” that you retire can impact you financially two ways: It gives you one less year of savings and one more year of future life. Finally, you must invest your assets in a sensible way so your risks are limited and you have some opportunity for growth.
We manage money for more than 800 families, and we have dedicated much of our investment advisory practice to finding combinations of strategies that help people make sure their money lasts for a lifetime.
Last year we wrote several articles about planning retirement withdrawals on this topic. We identified and discussed the inevitable tradeoffs, and outlined several ways investors can maximize their chances of meeting their retirement objectives. I recommend these articles to you if you have not studied them already. You’ll find them on our Web site. I’d especially call your attention to “The Best Retirement Portfolio We Know,” “Market Timing, a Retiree’s Friend” and “Retirement Income That Never Runs Out.”
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