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RISK: How Much Is Too Much?

10/27/00 11:09:26 AM PST
by Jason K. Hutson

Every investor seeks a desirable return on his investment, but don't forget to take into account the risk involved, which can take its toll not only on the return figures but the investor as well. Here's how to build a portfolio by reducing risks and maximizing returns.

When venturing into the investment world, a rule of thumb is to not expect high returns unless you take on high risks. Think of risk as the possibility of losing money. Unfortunately, this isn't easy to quantify, so from a financial perspective, we'll define it as the volatility of investment returns. A return is the profit you make on an investment, usually expressed as an annual percentage rate. Mutual funds commonly list their returns as percentages. For example, an annualized return of 11% since inception means that if you had invested from the beginning of the life of that fund, your investment would have gained 11% each year. Percentage gain is calculated by:

1. Subtracting the initial investment amount from the current value of your investment and adding any income such as dividends and/or interest not reinvested.
2. Dividing the amount from step 1 by the initial value of your investment.

Most investments present a tradeoff between reward and risk: the higher the risk, the higher the potential return. Figure 1 shows returns for US Treasury bills, long-term government bonds, long-term corporate bonds, small-cap stocks, and large-cap stocks against inflation from 1960 to 1999. As you can see, small-cap stocks are those with the greatest price fluctuations, meaning they carry the highest risk.

Figure 1: RETURNS OF VARIOUS ASSET CLASSES OVER INFLATION. The risk–reward tradeoff will vary among the different asset classes. Generally, small-cap stocks are considered the most risky, whereas US T-bills are practically risk-free.
Quantifying risk
Unfortunately, measuring risk is difficult and better left to the professionals, since it involves statistical calculations. However, having a general idea of the risks involved in any investment will make you a better investor. One effective method is to consider the returns available on a risk-free investment, such as Treasury securities or government-backed certificates of deposit. Any return on an investment over and beyond these is a reward for risk or risk premium. Check out the example in Figure 2, where you can see the returns of small-cap stocks, which carry a high risk compared with Treasury bills, which are considered riskless securities. Because of their high risk, small-cap stocks are volatile, and in some periods their returns were lower than those of T-bills.

Nobody knows your risk tolerance level better than you do, and ultimately, your investment choices will depend on the risk-reward tradeoff you are willing to tolerate. If there are specific investments you wish to consider, analyze each against a low-risk asset to anticipate your risks.

Have a plan
Before you build your portfolio, you need to map out a financial plan. Investors have numerous choices when it comes to investing their capital. Common investment vehicles include savings accounts, money market accounts, Treasury bonds, CDs, insurance, real estate, mutual funds, stocks, options, and futures. Each of these investment vehicles has a different risk-reward ratio, and it would be to your benefit to rank them from the least risky to the most risky.

Figure 2: SMALL-CAP RETURNS AGAINST US T-BILLS. The difference in returns between small-cap stocks and T-bills clearly shows that the riskier the asset, the more volatile.

The following steps should be used as a guideline before putting capital into any investment venture.

1) Investment Profile: Consider your own risk tolerance. As an investor, are you aggressive or conservative? Do you prefer short, closely held investments, or do you have time and patience? These questions can be considered not only for each investor but also for each investment. The quiz in the sidebar %93What type of investor are you?%94 can help you answer these questions and determine the amount of risk you are willing to tolerate.

2) Investment Goals: Set objectives with clear goals and the time frame you have to achieve them. The most effective way to do this is to study the history of the stock you are interested in. True, history may not repeat itself, but it can still give you an idea of the kind of risk-reward ratio you can expect. Typically, I analyze a five-year chart of the stock and look for the lowest price the stock hit during that period. Then I divide this price by the stock price five years ago. This gives me an idea of the risk associated with that stock. To determine the reward, I divide the current price by the price five years ago. Although this may not be an accurate calculation of the risk-reward tradeoff, I have found it to be helpful. Some sample risk-reward ratios for different types of common investment vehicles can be seen in Figure 3.

3) Time Horizon: Will you be investing for one month, one year, 10 years, or longer? The time you hold an investment plays a big role in assessing risk. Studies have shown that risk decreases with time. Remember the October 1987 market correction? The Standard & Poor's 500 index was at 274.08 at the beginning of the year. In January 1997, this index was up to almost 800 points. If you had invested at the beginning of 1987 in a fund that follows the S&P 500 index, you would have an annual return of more than 18% after 10 years in spite of the crash, when it lost well above 20%. (See Figure 4.)

Figure 4: RISK REDUCES WITH TIME. In spite of severe drops in the markets, holding onto your investments for a long-term period generally increases your rewards.

4) Diversification: When investing in stocks, you are accepting two types of risk. One is company risk, which has to do with the performance of a specific company. The other is market risk, which is associated with the general market. Weak market conditions caused by economic conditions can bring down stock prices regardless of whether the company has sound fundamentals. Company risk is something you have control over, whereas market risk cannot be avoided. Including stocks of several companies in your portfolio can reduce company risk substantially. For example, if you purchase only one stock, you are accepting 100% company risk, but if you purchase 10 different stocks, you are spreading out the company risk among these 10 companies. Approximately 70% of total risk is company risk, and the remaining 30% is market risk. By diversifying your portfolio, you will be minimizing a major portion of your risk.

5) Asset Allocation: You need to decide how to allocate your capital. This is critical in meeting your objective of maximizing returns while minimizing risk. Although there are several asset classes you can invest in, the three you should focus on are cash, bonds, and common stock. Of the three, cash reserves are the least risky. Bonds produce higher yields than cash reserves, but their value fluctuates in correlation with market conditions. So by investing in bonds, you are exposing yourself to a degree of market risk. Stocks offer higher returns than cash or bonds, but a substantial risk is involved. Analyze the risk-reward tradeoff for each class before deciding how much to allocate to each. Typically, an individual with an investment horizon of 20-plus years should allocate a larger percentage of his investment capital to stocks. A typical portfolio would consist of 80% stocks and the remainder in bonds and cash. Someone who has between 10 to 20 years to reach his or her financial goals should take a moderately risky approach. To achieve this, a typical asset mix might be 60% stocks, 20% bonds, and 20% cash. If you have less than 10 years to invest, you should probably focus on investments that produce income and that have the least amount of risk. A portfolio consisting of 40% stocks, 40% bonds, and 20% cash would probably be most appropriate.

6) Selection: Once you have a general idea of how you want to allocate your investment dollars, you need to select individual securities to build your portfolio. It is nearly impossible to calculate the risk-reward ratio of every stock that is traded; that task is best left in the hands of a financial professional, such as a financial planner or investment advisor. Alternatively, you could invest in mutual funds instead of selecting individual securities to purchase. In any case, being aware of your risks will put you in a better position to approach a financial professional or to select appropriate mutual funds.

7) Monitor Portfolio: Get in the habit of measuring the performance of your portfolio regularly. Is your portfolio moving in the direction of your objectives? If you feel your objectives are not being met, then you may need to make adjustments. Keep in mind the risk-return tradeoff. A riskier investment will generate higher returns over the long term, so don't get hung up by short-term volatilities. Several software packages ease the task of monitoring your portfolio; the most popular are Intuit's Quicken and Microsoft's Money. Various financial Websites also offer this feature.

In the end
Now that you know how to determine the potential risk you may be taking with a particular stock or investment, you can better evaluate whether it is worth the potential reward. If your investment isn't surpassing the yearly returns you could be getting with CDs or T-bills, then save yourself the headache of the riskier investment and go with a more secure investment, one that offers a fixed return or is backed by the US government. Government-backed securities are often used as a benchmark when evaluating the annual return on an investment, since their performance is indicative of what your money could be earning with almost no risk.

The reward you receive for any given investment is the profit you have earned on it over a particular time frame minus the effort it took. If your risk tolerance, investing time frame, and time available to commit to investing are suited to withstand the volatilities of riskier investments, then by all means, don't hesitate to add these to your portfolio. However, if you are easily overcome with worry and fear when the value of your portfolio decreases, then selecting a more conservative strategy may be the better alternative.

Investor Quiz

What type of investor are you?
Investing time frame, amount of capital, personal discipline, and temperament: These all play a part in your investment success. Naturally, we all want to make the most of our talents and abilities when it comes to investing. Toward that end, try asking yourself a few questions. The questions presented here are designed to help you determine what type of investments will work best for you.

Visualize an investment that you are considering and answer the following questions with that investment in mind. At the end, we'll analyze what your final score may mean for you as an investor.

1. What is an appropriate time frame for this investment?

(1 point ) Less than two weeks
(2 points) Two weeks
(3 points) One month
(4 points) Half a year
(5 points) One year
(6 points) 3-5 years
(7 points) 10 years
(8 points) 20 years
(9 points) 30 years

2. How much of your available capital are you going to put in this investment?

(1 point ) 100-91%
(2 points) 90-71%
(3 points) 70-51%
(4 points) 50-31%
(5 points) 30-11%
(6 points) 10-6%
(7 points) 5-3%
(8 points) 2-1%
(9 points) 1%

3. How patient are you and how does this affect your investing?

(3 points) Lose patience only under the most trying situations
(5 points) Control my emotions well in most normal circumstances
(7 points) Frequently lose patience during everyday tasks
(9 points) Rarely display any patience for anything

4. How assertive are you and how does this affect your investing?

(1 point ) In control and ready to act at all times
(3 points) Rarely hesitate in trying situations
(5 points) Control my actions well in most normal circumstances
(7 points) Lose assertiveness only under the most trying situations
(9 points) Commonly change my mind

5. How well do you follow rules under very extreme circumstances?

(3 points) Rarely act against a rule
(5 points) Follow rules in most normal circumstances
(7 points) Second-guess and delay important decisions
(9 points) Jump at the chance to bend the rules

Add up the numbers corresponding to each answer. If you scored fewer than 25 points, you might be suited for a short-term, high-risk investment. If you scored more than 25 points, you are more suited toward longer-term investments with less decision-making involved. Try this test again with different investment ideas in mind, and if after several tries you haven't fit the profile of the high-risk investor, then you should probably stay away from high-risk investments altogether. -- J.H.

Jason Hutson is an Industrial Engineer for Technical Analysis, Inc.

Jason K. Hutson Staffwriter. Enjoys trendlines, support and resistance, moving averages, rsi, macd, adx, bollinger bands, parabolic sar, chart formations, volume analysis.

Biggest hint:
"NEVER trade without a stop loss order."

Title: Industrial Engineer
Company: Technical Analysis, Inc.
Address: 4757 California Ave SW
Seattle, WA 98116
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