Thursday, April 6, 2006

Winning the Game of Risk

News Analysis
April 6, 2006

Business Week Online

Winning the Game of Risk

Some pros say investors aren't paying enough attention to risk. Here are some smart steps to help protect your investments


This may sound amazingly self-evident, but it's worth repeating: Investing is inherently risky. And too much risk may be hazardous to your financial health. Anyone who has ever watched a stock like Google (GOOG ) or General Motors (GM ) execute a power-dive knows how much sudden downturns can hurt a portfolio.

But unless you wish to stash your assets in the Bank of Posturepedic, you will have to take on some risk as you put your money to work. The trick is to take on the right amount for your age and your financial circumstances.

It's not always easy, especially when financial market upswings can make investors complacent. Market veterans have increasingly warned against excessive risk. Most recently, bond-fund guru Bill Gross cited a possible downside in indexes he deems overvalued. "The crash of risk assets and their return to normalcy may be hard to time, but...these periods never end well," the PIMCO chief investment officer wrote in his latest monthly outlook.

FIRE ALARM.  How much risk is too much? "It's difficult to define," says Phil Edwards, managing director of Standard & Poor's Investor Services. One gauge of risk is standard deviation, which measures the volatility of a mutual fund's returns. The Standard & Poor's 500 index has a standard deviation of 17. This figure should be higher for small-caps and lower for large-caps. The number of securities in a fund and their level of liquidity also determine its risk.

Fresh risks loom as baby boomers near retirement (see BW, 7/25/05, "More Risk -- More Reward"). Retirees don't only have to worry about losing money. They've got to contend with inflation, rising health-care costs, and the chance they'll outlive their assets, too.

Not insuring against those risks "is the same as not insuring my home against fire," says John Diehl, vice-president for advanced products marketing at The Hartford. The company is one of many selling products to protect against these upcoming perils.

The biggest risk? Not saving, says S&P's Edwards. Fortunately, investors can take a few steps to make sure that their portfolios reflect a sensible degree of risk. This Five for the Money finds ways investors can steer away from the hazards on the road to financial security.

1. Act Your Age
It's never too early to save. The probability a stock portfolio will lose money decreases dramatically over long periods of time, financial planners say. In other words, the sooner you start socking away, the less likely your assets will be at the mercy of the market's whims. "Time diversification is your first defense against worrying about portfolio volatility," says Ken Solow, chief investment officer for Pinnacle Advisory Group.

At the other end of the spectrum, severe declines can be disastrous for the newly retired. That's why older investors should gradually shift their assets toward less-risky investments, like bonds, financial planners say. But they caution against moving too much too soon.

Meanwhile, retirees ought to closely monitor their portfolios. "You should only really be taking annual withdrawals in the range of 4% of your total portfolio value," says Diane Pearson, director of financial planning at Legend Financial Advisors. She says some investors get into the habit of withdrawing a constant dollar amount, which each year cuts out an increasingly large portion of their portfolios.

2. Celebrate Diversity
Diversify, diversify, diversify. Spreading assets across investments that move independently of each other is the most fundamental way to guard against portfolio risk. When an automotive stock is down, for instance, a health-care stock might be moving in the opposite direction.

A broadly diversified set of holdings will include many investments that tend to perform in different ways. Owning a pair of index funds like the Vanguard Total Stock Market Index Fund (VTSMX ) and the Vanguard Total International Stock Fund (VGTSX ) provides access to thousands of securities at little cost, notes Rick Miller, CEO of Sensible Financial. "Diversification is easier now than it's ever been," he says.

Naturally, some asset classes are riskier than others. A "classic" balanced portfolio of 60% stocks and 40% bonds will have greater potential downside than a portfolio of 40% stocks and 60% bonds. Within an equity allocation, investors may want to diversify between domestic and international stocks, small-cap and large-cap stocks. Financial advisers often recommend tilting stock holdings toward value, rather than growth, to further reduce risk.

3. Look Under the Hood
Don't assume a portfolio is diversified just because it includes five or six mutual funds. Many funds have holdings that actually overlap. "Dig a little bit deeper," says Pearson.

Even if two funds seem to have different strategies, they may not provide true diversification. A growth fund might invest in a surprising number of value stocks, or vice versa, while a domestic fund could hold a smattering of international stocks.

Investors can learn more about funds' holdings through various financial Web sites, including Morningstar (MORN ) and Lipper. BW Online has a fund screener with this information, too.

4. Consider Alternatives
A less traditional way to get further diversification is through alternative investments. Asset classes like commodities, commodity futures, and hedge funds tend to move differently from stocks and bonds. Some financial planners say alternative investments can protect investors against risk in an environment where both stocks and bonds underperform.

Owning real estate can be another way to diversify. "Many firms look at real estate as an alternative asset, but we think it's a fundamental holding," says Kevin Gahagan, a principal with Mosaic Financial Partners. He likens a portfolio to a garden, where different asset classes will be in bloom at different times.

Real Estate Investment Trusts, or REITs, and REIT mutual funds provide a liquid means of investing in real estate (see BW, 12/26/05, "After the Housing Run-Up"). But some say REITs move too much like small-cap value stocks to ward off additional risk.

5. Stay the Course
Once you have a financial plan in place, stick to it. Behavioral finance suggests investors tend to make the wrong decisions at the wrong time, often for the wrong reasons. "One of the real risks to long-term portfolio success is allowing emotion and psychology to trump sound strategy," Gahagan says.

Chasing hot sectors in a bull market or fleeing from equities in a downturn may make sense at the time, but they're rarely smart financial strategies. Asset allocation shouldn't change with an investor's mood. A properly diversified portfolio at the onset of the 2000 bear market would have been out of the red before an all-equity portfolio, according to Gahagan.

Even risk-averse investors should expect to weather occasional declines. But taking a few savvy steps can increase the odds a portfolio will come out ahead.

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