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Sharpen Your Investment Sense with Risk Tolerance Training
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By Clifton Linton
Senior Writer, mPower |
"Those guys are nuts. I can't believe people want
to do something that dangerous."
That was Ty Dickerson's opinion a few years ago as he stood
next to the Chicago Mercantile Exchange's Eurodollar futures pit watching hundreds of
yelling, gesturing traders swap millions of dollars worth of contracts. A slip could spell
a trader's financial ruin.
Dickerson's words were ironic. As a volunteer firefighter
in College Park, Md., Dickerson, 41, regularly risks his life by running into burning
buildings as others flee. Eurodollar traders only risk money. Asked about this recently,
Dickerson said "I feel comfortable doing fire fighting. I'm trained and know what to
expect. ... Trading with money is different. I'm not trained in that field."
The fact that he feels this way even after what happened on
Sept. 11 shows the importance of training and education when dealing with risk, in any
field.
Retirement investors can take some lessons from Dickerson
and the traders. Despite the different venues in which they operate, traders and
firefighters are professionals who understand the risks they face and know how to deal
with them.
Declining retirement account balances have stunned many
workers over the past year, particularly recently, and some have sold their holdings in
panic. Often, this is because they don't understand the risks they face and consequently
don't have the background to develop an escape plan.
As Dickerson would say, they haven't had the training.
Risk Is Everywhere
The key is identifying risks and prioritizing them so you
understand when a real threat to your retirement security emerges, planners say.
The investment risk we're talking about refers to
the fluctuation or volatility of returns on your investment.
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| "My experience is that most
investors overestimate their risk tolerance." |
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| — Professor Herman Manakyan,
chairman of the Department of Economics and Finance at Salisbury University, Salisbury,
Md. |
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The risk many novice investors fear is losing their
principal. In most cases that's an unreasonable fear. Unlike a casino bet where you
can lose your entire stake on a single draw of cards, when you purchase securities or
mutual funds there's a good probability that the company will survive almost any
catastrophe and pay some kind of return.
Yet folks motivated by this fear often sell their
investments after a serious market fall. While thinking this will reduce their risk, they
may incur a new one — locking in losses, and ending up with low-performing
investments.
"There's the risk ... of selling stocks when you think
they are volatile and having them go up 40 percent while you are on the sidelines,"
said Scott Lummer, chief investment officer with mPower Advisors, L.L.C. mPower provides
investment advice to retirement plan participants and is the publisher of this Web site.
"What novices don't understand is that there are more
risks than losing your capital," said Darrell Canby, a certified financial planner
with Canby Financial Advisors, LLC in Framingham, Mass.
For instance, they might not have enough money at
retirement. This risk can be mitigated through disciplined saving and developing a sound
investment strategy.
Even if you create a strategy with minimal investment risk,
like buying Treasury bills, you still will need to contend with other ever-present risks
such as business failure, market declines, inflation, interest rate changes, currency
fluctuations and political upheaval.
Another major risk that savers face is inflation. Investing
a portion of your portfolio in stocks, which historically have beaten inflation, can
minimize that risk. But that requires you to take some investment risk.
Greed and Fear
When investors don't understand the risks they face, they
act on emotion rather than logic. They panic, buying securities when the price is high and
selling when it's low.
To understand why people panic it helps to know the
emotions motivating all investors — fear and greed. Even the best investors
and traders are subject to these emotions. But successful investors recognize them and
work continuously to overcome them.
"If you lay a ruler out and at one end have fear and
the other greed, you want to make most of your (investment) decisions in the middle. You
want to have a balanced perspective," said Richard Lee, certified financial planner
(CFP) and chartered financial analyst (CFA) with Dallas-based Lee Financial Corp.
Professional Insight
Jon Najarian is a 20-year veteran trader on the Chicago
Board Options Exchange. When told firefighter Dickerson's view about trading's dangers, he
disagreed. "He didn't understand. He perceives a lot of risk," he said, adding
that successful traders actually take as little risk as possible with each trade. They try
to make as many trades as possible to make a few bucks off each.
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| "You would prefer not to lose more
than one night's sleep every four to five years." |
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| — Terrance Odean, assistant
professor of finance at the Haas School of Business at the University of California,
Berkeley. |
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That means traders need to be patient and work at their
strategy; for retirement savers, that translates into regular saving combined with
sticking to an investment plan.
Test Your Risk Tolerance
An important step is to determine your risk tolerance. You
need to figure out how you will react in a potentially stressful financial situation.
Unfortunately many folks don't do a good job of that, said Professor Herman Manakyan,
chairman of the Department of Economics and Finance at Salisbury University in Salisbury,
Md.
"My experience is that most investors overestimate
their risk tolerance," he said.
Consider factors such as your time horizon, retirement
goals, whether you have the money to take risk and if you feel comfortable taking risk.
"You would prefer not to lose more than one night's
sleep every four to five years," said Terrance Odean, assistant professor of finance
at the Haas School of Business at the University of California, Berkeley.
Savers with a long time horizon can afford to take
on more investment risk because their investments will have more time to recover from
potential losses. Many planners suggest that those with a time horizon of 10 years or more
invest at least a portion of their savings in stocks. But stocks carry more investment
risk than Treasury bonds or savings accounts.
Just remember, you can't make money without taking some
risks. It's a matter of knowing your own comfort level.
David Diesslin, a CFP with Diesslin and Associates of Ft.
Worth, Texas, uses the following question to gauge his clients' views toward risk:
"Would you prefer to own cash when the market goes up, or stock when the market goes
down?"
Clients who answer "cash" tell him that they are
more interested in protecting their principal than increasing their nest egg.
Clients who answer "stock" tell him they are more
interested in investment growth than principal preservation.
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| "We need to know a level of panic,
as a way to gauge risk tolerance." |
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| — David Reiser, CFP, senior vice
president of investments with UBS Paine Webber and co-author of Wealth Building. |
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Another exercise is to imagine your portfolio and predict
when you would sell your investments — when they declined by 10 percent? 20 percent?
30 percent? The level at which you think you would sell is your risk tolerance. (In other
words, the higher the percentage, the more risk (volatility) you can stomach, and vice
versa.)
"We need to know a level of panic, as a way to gauge
risk tolerance," said David Reiser, CFP, senior vice president of investments with
UBS Paine Webber and co-author of Wealth Building.
A third way to help figure out your risk tolerance is to go
through a financial physical exam. Look at your financial picture — your assets,
liabilities, budget and cash flow. Then set your goals and determine the compromises you
are willing to make to reach those goals. For example, you may need to assume a little
more risk than you would normally feel comfortable with or trim back on use of disposable
income so you can save more.
Doing these exercises won't be easy or painless. "It's
better to feel the pain hypothetically than to have the pain" in reality, Odean said.
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The information provided here is intended to help you understand the general issue and
does not constitute any tax, investment or legal advice. Consult your financial, tax or
legal advisor regarding your own unique situation and your company's benefits
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