In the movie “Wall Street”, ruthless investor Gordon Gecko famously declared that “greed is good” because it encourages risk-taking. His unchecked greed and arrogance, of course, ultimately led to his downfall.
It is often hard to accept the idea that risk is good; we are, after all, living in turbulent times. The possibility of random acts of terrorism remains very high. The economy seems unable to sustain its anxiously awaited recovery. Unemployment has risen to 6% and layoff announcements continue. The stock market just closed its third straight year of losses (with bigger losses in each successive year), warnings abound that the bond market is ripe for decline when interest rates go up, and real estate has benefited from low interest rates to the point that it could be the next bubble to burst.
Nearly every decision and activity, of course, involves some risk, and considering the consequences of avoiding risk altogether helps us appreciate reasonable risk. We clearly do not want to forfeit all of our freedoms in exchange for complete protection from terrorism. We would seldom venture out of our self-contained fortress homes. Careers would stagnate, along with the knowledge gained from experimentation and failure. Any investments would only be in the most conservative vehicles possible so there would never be a decline in value.
Risk is necessary for growth and progress, and successful investing, as opposed to simply saving, requires both assessment and acceptance of risk. First and foremost, investors must reconcile the tradeoff between risk and return. Simply put, over time an investor cannot pursue higher potential returns without accepting higher risk, and cannot avoid risk without giving up potential return. And the most conservative approach carries its own unique danger known as inflation risk, the very real possibility that investment returns will not keep pace with inflation and purchasing power will be eroded. Even after its three-year decline, the average annual return for the stock market over the last ten years was 9.34% compared to 7.51% for bonds and a meager 4.07% for money market funds.
In today’s environment risk, which should be based on looking forward, is often confused with outcomes, which are based on hindsight. In other words, if a course of action produced positive results it must not have been risky. This can cause investors to “chase performance” by abandoning poor-performing assets in favor of the most recent strong performers. This practice, combined with the inevitable cyclicality of most investments, creates a portfolio that buys high and sells low and is always in search of a new strategy.
How, then, can investors come to grips with risk? For the technically-minded, there are measures of volatility, specific risk and risk-adjusted returns. For the rest of us, here are some straightforward ways to keep risk in perspective.
Understand the risks – Long-term averages can mask risk, so also look at each year’s performance to gauge volatility. Use sector indexes as an indicator to avoid being seduced by an investment that has outperformed its peers in the short term. Struggle through the “risks” section of a mutual fund prospectus. And in the absence of specific information, rely on your own common sense. In investing, perhaps more than anywhere else, if it sounds too good to be true, it probably is.
Know your limits – An objective assessment of risk is useless without considering your own risk tolerance and disposition, and three years of declining stock values is a great test of investor resolve. Take a risk-assessment quiz, or simply ask your self how you would feel if your portfolio declined X% in a given period. Those with low tolerance for risk may have to adjust their long-term goals or save more, but being able to sleep at night is far more valuable than the potential gains.
Stay diversified – A common lament by investors has been that they weren’t aware they had such high exposure to growth stocks. In some cases this is a legitimate gripe, but in others it is convenient amnesia. While diversification – a mix of stocks, bonds and cash – will likely prevent a home run, it will significantly reduce volatility and is the best way to align risk tolerance and investment objectives. Review your portfolio once a year to confirm and maintain your diversification parameters.
Time is on your side – Time can fix most investment mistakes, and a time horizon of ten years or more will greatly reduce your risk. But many needs and goals are more immediate, and risk should be reduced as they approach. Consider going to cash for any needs in the coming two years; as with sleeping at night, any potential gains are not worth risking your goals.