As you decide how much to invest in stocks, a lot supposedly rides on whether you have knees of jelly or nerves of steel. But this notion of risk tolerance is a dangerous idea.
For proof, look no further than our reaction to recent market movements. Last year, risky technology stocks were all the rage. This year, we are ready to throw in our lot with cowardly money-market fund holders.
Our tolerance for risk, it seems, has plunged along with the market. But clearly, that doesn’t mean we should cut back on stocks. If we slashed our stock-market exposure every time we felt queasy, we would buy high, sell low and garner disastrous investment results.
“After the stock market has gone up, people think that the probability of the market continuing to go up is high,” says Meir Statman, a finance professor at Santa Clara University in Santa Clara, Calif. “When the market goes down, people think it will continue to go down.”
What to do? As we settle on our portfolio’s stock allocation, maybe we should forget about risk tolerance and instead focus on four other factors.
– Taking aim. “This fixation on risk isn’t getting us anyplace,” Statman argues. “Instead, people should think about the goals they have.”
You might want a cash reserve to cover emergencies and help you sleep better at night. But you also want to amass enough for retirement, which means buying stocks in the hope of notching high returns.
“One goal is to avoid being poor,” Statman says. “The other goal is having a shot at being rich. Each goal is desirable. The question is, how do we allocate our portfolio between these two goals?”
– Hitting the target. Unlike many financial planners, San Francisco investment adviser Tim Kochis doesn’t start by asking new clients about their risk tolerance.
“You’re not going to get a useful answer,” he contends. “People don’t understand risk very well. Most people will underestimate the risk of bond investments, because they don’t understand interest-rate risk. And even after the great performance of the past few years, they’ll overestimate the risk of a diversified stock portfolio over the long term.”
Instead, Kochis begins by both educating clients about risk and figuring out what sort of investment returns they need to meet their goals. He then presents them with a mix of stocks and conservative investments that he thinks will generate the returns they need.
“At that point, clients typically change their professed tolerance for risk, rather than changing their goals,” Kochis says. “Clients can see the tie-in between the portfolio’s risk and the accomplishment of their goals. “
Still, there is a downside to this approach. “Once you’ve shown people that the portfolio that is most likely to meet their future needs is an aggressive portfolio, they tend to ignore short-term risks,” argues Jeff Schwartz, a vice president at mPower, a San Francisco on-line-investment adviser. “But the problem is, it’s these short-term events that we react to.”
– Biding time. As you decide how to divvy up your money between stocks and more conservative investments, time is a critical factor. Even if you are an aggressive investor and you need high returns to meet your goals, stocks may not be a wise choice if you have a short time horizon.
“We think that any money needed in three years or less should be saved rather than invested, and that means Treasury bills, money-market funds and certificates of deposit,” says Minneapolis financial planner Ross Levin. “But most people’s time horizon is longer than they think. Your kid may be three years from college. But you won’t pay the last bill for seven years.”
– Pick a reasonable range. For all the talk about risk tolerance, it doesn’t appear to make much difference to the portfolios that financial advisers recommend.
Experts aren’t likely to suggest an all-bond portfolio. After all, a mix of 80 percent bonds and 20 percent stocks will have comparable portfolio gyrations, but with a significantly higher expected return.
At the other extreme, advisers probably won’t recommend an all-stock portfolio. They will plunk at least some money in conservative investments, to temper the stock portfolio’s price swings and provide money in an emergency.
In practice, the range gets narrower still. No matter what the client’s age or professed risk tolerance, experts typically recommend that long-term investors have 50 percent to 90 percent in stocks, Levin says.
Sound like a lot in equities? Initially, you may not be comfortable with such hefty stock exposure. But with time, you should get used to the market swings. And the fact is, without the stocks, you may not amass enough to reach your goals.
“Clients may indicate that they’re very risk averse,” says Eleanor Blayney, a financial planner in McLean, Va. “But they may not be able to afford to be that conservative.”
