Understanding Risk

Jane has organized her papers and completed the cash flow and net worth statements. She has a better idea of where she needs to go, but no idea how to invest. Jane is afraid of taking any risk, but she knows that some risk is necessary. But, Jane also realizes that until she started this planning process, she was taking the worst risk of all—moving into the future without a financial plan.

What is an investment? When you invest, you put your money to work, and expect it to earn more money. Many people confuse buying assets with investing. Buying a new car is not investing, because its value starts decreasing the minute you drive it off the lot. Buying an antique car may be investing, if you expect it to grow in value so that you can sell it for a profit.

The more investment risk you take with your money, the more you are likely to earn on your investment. However, the riskier the investment, the more likely it is that you will lose some or all of your money. So, how do you evaluate where you are on the risk scale, what your risk tolerance is?

Many women choose the least risky investments, including money market funds, bank certificates of deposit and savings accounts. These are high quality and low risk. But, they also provide minimal rates of return. These days, a money market fund may return 1% or less on your investment, which may match the rate of inflation, but your money is really doing nothing for you.

For planning purposes, we are thinking long-term, not short-term. It depends on your age, but let’s say you are now 50 and insurance tables predict you will live well into your 70s. Your investment horizon is at least twenty years, even at age fifty. Over twenty years, you can accumulate wealth through investments, but not if your investments are simply keeping up with inflation. You must take some risk to ensure some reward.
Jane is now 33, and figures she will work another 25-30 years before retiring. Jane begins to see that she can take some investment risk with her money because she has such a long time before she needs it.

Risk tolerance is very personal. You need to know what makes you comfortable and feeling secure and confident about your investment choices. At one extreme, you may have been influenced by parents who lived through the Great Depression and had no confidence in any type of investments, or you may have come from circumstances of poverty where having money “in the bank” represents your feeling of security.

Your risk tolerance also will depend on whether you have any specific financial goals such as college for a child or buying a home. Depending on where you are in planning and saving, you may need to take additional risks to meet your goals.

Someone in their 20’s can afford to take more investment losses over a 40-year working lifetime than a person in their 50’s. Of course, nothing is that simple. Someone in their 50’s who has never been involved in financial planning and is now trying to set aside sufficient retirement will have to take more investment risks to reach their goals.

The MOST important concept relating to risk and investments is called “risk diversification.” It’s the foundation for the “Modern Portfolio Theory” for which Harry Marcowitz won the Nobel Prize in the 1950’s, measuring risk and reward. He proved that a portfolio carrying different levels of risk would outperform any portfolio with single types of investments. The concept seems simple enough – when one goes down in value, another may go up and modify the effect. It’s now called “asset allocation.” Spreading your assets across investments with differing risks gives you a better chance of riding out market ups and downs. In other words, “Don’t put all your eggs in one basket.”

Your portfolio should look like whichever category you’re in:
TYPICAL ASSET ALLOCATION FOR YOUNG INVESTORS is medium risk: bonds 45%, stocks 54%, and cash 1%.
The typical asset allocation for MID-LIFE INVESTORS includes bonds 40%, stock 50%, and cash 10%.
For PRE-RETIRED INVESTORS, the pie could look like bonds 36%, stocks 45%, and cash 19%.
And, for RETIRED INVESTORS, the pie could use bonds 33%, stock 40%, and cash 27%.

Of course, financial planners have different opinions. But, usually the retired investor allocation will include more cash, while the young investor allocation will include a minimum of cash.

However, your comfort level comes first.

Keep in mind that over the years your risk tolerance will change and you need to ensure that you update your profile and your investments.

As a securities attorney, I have seen many cases where investors have sued their brokers when they lose money. The claims primarily relate to misrepresentations by the broker over the investment risk recommended to the client because the client’s circumstances have changed and the broker did not update the client’s risk profile. Brokers are required to update a client’s risk profile at least annually, but this obligation should not be left to the broker or planner alone. You need to be active in monitoring your own investment portfolio by continually updating your broker or planner adviser on your risk tolerance and circumstances. No investor client is happy when they lose money and given the market’s propensity to move up or down, losses happen. But, I have never seen an investor client sue a broker over losses when the broker and the client have spent time understanding the client’s risk tolerance.

As for Jane, she needs to spread her investment risks across different types of securities. Her employer-sponsored 401(k) plan offers different investments, and now she knows why she has these choices. But, she needs more education on what her 401(k) means, as well as which investments will be best for her.

About the Author: Lyn Striegel is an attorney in private practice in Chesapeake Beach and Annapolis. Lyn has over thirty years experience in the fields of estate and financial planning and is the author of “Live Secure: Estate and Financial Planning for Women and the Men Who Love Them (2011 ed.).” Nothing in this article constitutes specific legal or financial advice and readers are advised to consult their own counsel