About the start of 2001, this retiree became a client, giving us $125,000 of his money to manage in that strategy, which is invested 25 percent in U.S. equity funds, 25 percent in international equity funds and 50 percent in bond funds. Every asset is defensively managed with market timing, and that appealed to him.

We talked for more than 90 minutes as he opened his account. Because he was used to the complete safety of CDs, much of the discussion was about investment risk. We talked about the possibility that in the short term he could sustain losses from being in equity and bond funds. He was quite comfortable with that notion, and together we decided that he should not have much trouble with exposing about 7.5 percent of his portfolio to a moderate amount of risk.

He understood that the Worldwide Balanced Portfolio has a built-in one-year loss expectation of 6 percent, and he said he accepted that. We discussed the possibility that he might get nervous, but he assured me he would ride out the short-term ups and downs while he sought the long-term objective of leaving a more substantial estate to his heirs.

Soon after he opened his account with us, the stock market turned ugly. In the first quarter of the year, the Standard & Poor's 500 Index fell 12.1 percent and the Nasdaq Index lost a stunning 25.5 percent. As this was happening, the financial news seemed to portray an ever-gloomier outlook.

Our office started getting frequent calls from this client, who was as nervous as a cat while watching the market dive. (When he opened the account, I had sensed his nervousness, but he had assured me in advance that he wouldn’t be a frequent caller.)

Three months after he opened his account, my client’s balance had declined by less than $1,000. Because of our timing systems, only $17,000 of his money – one-tenth of 1 percent of his whole portfolio – was exposed to equity funds. The rest of the money we managed for him was in bonds and a money-market fund.

The client called in great distress. I remember he said: “I feel like it could go down forever.” He understood that his fear was irrational, but that didn’t stop him from worrying that his $125,000 investment would somehow infect everything he had worked for and saved. His experience was of raw fear, unhindered by facts.

The anguish was just too much for him, and he closed his account after losing half a percent of his Worldwide Balanced Portfolio during a time when the stock market was down by 10 percent.

What’s the lesson here? I’m not sure, exactly. We focused on risk in our discussion. We educated him. We certainly did not expose any significant part of his portfolio to the possibility of loss. We did all the right things, and in this case he – and we – discovered later that he simply didn’t belong in the equity markets.

Perhaps the lesson is that risk is at least as much emotional as it is objective and quantitative.

I’ve been in the investment business since the 1960s and I have spent many hours thinking about, reading about and talking about managing risks. I know it’s one of the most important parts of being a successful investor.

Here’s something that we wrote to our clients in 1998 and again in 2000:

“In the very good times, it seems as if investing is about accepting wealth. You put down your money, almost like planting it in a garden, and watch it grow. But in fact, in good times and bad, investing is really about managing risk and managing your emotions. If you want to be a successful investor, you’ve got to do at least a decent job at both those tasks.”

Yet despite our best efforts over many years, I’m still disappointed that we haven’t mastered the management of emotional risks. In a way, this is the most difficult part of investing.

If we can define risk in terms of what it really is and how real people experience it, we may get some insight.

There are many mathematical definitions of risk, including standard deviation, drawdowns, worst 12-month periods, etc. These are good descriptions of ways to measure and compare risks, and they are great for making statistical comparisons. But I don’t think they tell us enough about how individual investors experience risk.

What is risk? The American Heritage Dictionary defines risk as “the possibility of suffering harm or loss.” Other definitions use the words danger, uncertainty and hazard.

Here’s my own, a slightly modified definition of risk: a possibility that you invite into your life, that you could lose something important. That something might be your physical safety, a relationship or something financial.

This definition is useful in a couple of ways. First, it says that risk is not theoretical, as in statistical measurements. It is about really losing something, in this case money. Second, the word “invite” implies that risk is not something that is imposed on you from the outside; it is something that you choose, accept and even willingly encourage.

Obviously, nobody invests money hoping to lose it. So why take a risk at all? Because investing is essentially an area of life in which people get paid for taking risks. It’s neatly summed up in the old saying, “Nothing ventured, nothing gained.”

In a very real way, investment returns are commensurate with risks. In the lowest-risk investments, where safety is very high (T-bills, CDs, savings bonds and money-market funds, for instance) the very best return you’ll ever get and the very worst return you will ever get are very similar: a modest profit.

The reason investors take risks is that a modest profit isn’t enough for them. In general, the more risk you are willing to take, the more return you could possibly receive. But this rule of thumb implies that you take intelligent risks based on understanding and knowledge instead of random risks based on bravado and recent hot performance.

When you manage your risks and your returns intelligently, you look for ways to capture a premium return for whatever risk you take. That usually means careful shopping for the best rates of return, the lowest expenses and other costs, the most efficient way to get what your portfolio needs.

Let’s define two categories of risk: Objective risk, which can be measured, and emotional risk, which depends on each person’s perceptions. Here’s an example: If you are a CD investor, the easiest source is your own bank. But it’s highly unlikely that your own bank happens to have the very best deal offered anywhere. To do business there, you will have to take whatever is offered. On the other hand, you can shop around and perhaps find a higher interest rate at a bank 1,000 miles away.

The objective risk of a certificate of deposit issued by a distant bank is the same as that from your local bank. Both are deposits guaranteed by the U.S. government. But the distant bank may have more emotional risk: You can’t walk into a branch and talk to the manager. The hours of business of a distant bank may be different, and you may never know anybody there except over the phone.

But if the distant bank pays a higher interest rate than your bank, you are in effect earning a premium return for the small amount of “emotional risk” you are taking by dealing with the distant bank.

To take a much bigger leap for another example, there’s a lot more risk in investing in stocks (even when you follow our advice and do that by investing in broadly diversified no-load mutual funds) than there is in keeping your money in the bank. But the reward from stocks can be much greater over long periods of time. Higher risk and higher rewards go together. It’s a basic fact of investing life.

Sometimes the exact same level of risk looks very different from an objective point of view than it does from an emotional point of view. Somebody with a $1 million portfolio may take a 5 percent one-year loss quite in stride – until he realizes that he just lost $50,000 and that used to be an entire year’s salary. Rational or not, for some people the thought of a year’s work going down the drain is too much to handle. (On the other hand, somebody who had earned $250,000 a year might not flinch at losing $50,000.)

I think we do a reasonably good job of dealing with objective risks. We can compute the historical risks of various kinds of portfolios and express them several ways. For example, if you invested in the Standard & Poor's 500 Index at the start of 1970 and held onto it, reinvesting dividends, through the end of 2000, we know what would have happened.

You would have received an annualized return of 12.9 percent. That looks mighty good, unless you can recall vividly the shattered confidence of 1973 and 1974, the “crash” of 1987 and the stunning bear market of 2000.

Looking back, we can measure the risks you would have taken. Your investment during those 31 years would have had a standard deviation of 17.5 percent, a figure that is useful to statisticians but is meaningless to most people. But you would have experienced at least one calendar month in which your portfolio dropped by 21.5 percent. The worst 12 months in this 31 year period handed you a loss of 38.9 percent; the worst 36-month and 60-month periods experienced losses of 28.6 percent and 11.2 percent, respectively. We also can use those same measurements to compare the performance and risks of other things you could have invested in.

But what do you do with that information? That is the tricky part. It’s easy after the fact to say “I could handle that,” because you already know how it turned out. But when you look at the next 31 years, through the year 2032, you have no idea how an investment in the S&P 500 Index will turn out. In one case, you’re looking at history. In the other case, you’re looking straight into the eyes of risk, because you can’t know the future.

This is why I often say that “There is no risk in the past. The only risk you face is in the future.”

Emotional risk involves confronting what you cannot know. Some people deal with the future quite cautiously, others are much bolder. Life is full of risks. When you ask somebody for a date, you take a risk. What if she (or he) says yes? What if the answer is no? What if you just get laughed at? The same goes for accepting a date, choosing a spouse, taking a new job, going to college. Some folks are very cautious about some things and apparently reckless about others.

Formulas simply don’t work for dealing with the huge variation in what we call risk tolerance, for the huge variety of factual circumstances people find themselves in, and for the high emotional content of risks.

Here’s another client story that illustrates why risk is a challenge. A couple recently came to us for help with their portfolio, which consisted solely of Treasury bills. That’s all they’ve invested in since they retired in 1982 – and that obviously reflects their comfort level.

It’s easy to conclude that these people were quite risk-averse. But in 1982, when they retired, they probably thought they didn’t need to take any risks. In that year, one-month T-bills paid 10.5 percent interest; inflation was 3.9 percent. With an inflation-adjusted return of 6.6 percent, they must have thought they had found a risk-free financial nirvana.

But the “great deal” didn’t last very long. Looking back now, it’s easy to say this couple should not have expected it to. Since 1926, Treasury bills have had an inflation-adjusted return of only 0.7 percent. From 1982 through 2000, T-bills did a lot better than that, returning 6.2 percent during inflation of 3.3 percent for an inflation-adjusted return of 2.9 percent. That’s much less than what this couple had the year they retired.

In mid-2000, T-bills were paying 5.7 percent, and by mid-2001 the yield was down to 3.4 percent. Forgetting about inflation, that’s a loss of two-thirds of the investment income this couple had when they retired. By the time they came to us, it was obvious that their portfolio was no longer meeting their needs.

We decided with them that they needed to withdraw 6 percent of their principal each year. They wanted the amount of the withdrawal to grow, and they didn’t want to invade their capital. That of course is a very tough order to fill, and it’s impossible with just T-bills. To provide growing income, their principal would have to grow. That meant some of their investments had to be in equities, subjecting part of their portfolio to the risk of a year like 2000, when many investors lost 10 to 20 percent of their money, and some lost much more.

The choices facing this couple were stark: They could stick with their “safe” T-bill investments and accept a declining standard of living. Or they could invest some of their money in equity funds, from which their returns would be uncertain and from which they would almost certainly have to sometimes dip into their capital.

“Dipping into principal” is an emotional issue for them, as it is for most retirees. But in this case it was the only way to deal with their overriding problem: They simply do not have enough capital to live as they want to live and still invest very conservatively.

If you’re an advisor, how do you determine the risk tolerance of investors like these? In the end, they really had no choice except to accept some risk. And it’s ironic that if they had been willing to take more risk when they retired 19 years ago, they might not have to take the risks they must take today. In general, investors should take less risk as they get older, and this couple was forced to move in the opposite direction.

What’s your goal?

At my investment workshops, I usually ask for a show of hands to these questions: “How many of you have a primary goal of beating the market?” Very few hands go up. “How many people want to get the highest return possible within your risk tolerance?” Typically, that prompts more than half the folks in the room to raise their hands. “How many of you want to find the lowest-risk way to reach your objectives?” Usually the hands that go up in answer to this question are raised sheepishly, as if they are embarrassed to admit they want a low-risk strategy.

Yet when I ask people what their risk tolerance is, few have thought about it methodically and thoroughly. Some are quite unrealistic, wanting annualized returns of 15 to 20 percent without ever having to lose more than 10 percent in any 12-month period. Others seem full of bravado, claiming they can tolerate heavy losses in order to make high returns. The problem is that the high returns are never assured; that became painfully obvious to so many investors last year and early this year, when the market looked as if it were going down forever.

In addition, few people can tell me what annual rate of return they need in order to achieve their goals. This makes it very tough to figure out what level of risk is appropriate for them.

There’s an old saying on Wall Street that the stock market is driven by just two emotions: fear and greed. Though this is an oversimplification, there’s a lot of truth in it. And some investors may be able to use that model to get some insight into what is driving their own investment decisions.

Referring back to the three questions I ask at my workshop, I’d like to propose the following as one possible interpretation of the answers. (Notice I am not saying this is the truth, only one possible interpretation which may be useful.)

I think greed drives people to say they want the highest returns they can get within their risk tolerance. I think fear drives people to say they want the lowest-risk way to reach their objectives. I think pride drives people to say they want to beat the market.

These three words, greed, fear and pride, are probably too strong to describe the emotions that lead people to want better lives for their retirement years and to want a sense that they have not been left in the dust.

But it’s very easy for legitimate desire to turn into greed. When that happens, investors get carried into excesses like the technology bubble of 1999 that burst in 2000 and 2001. It’s very easy for legitimate caution to turn into fear. When that happens, investors avoid risks that they can afford and that they should take. And it’s very easy for investors to forget about their own goals and treat investing as a competitive sport where “beating the market” is what matters most. When they do that, investors usually take too much risk and receive too little reward.

All of us have some combination of those emotional forces, and they determine how we live our lives beyond just investments. I invite you to think about how important each one of these factors is in your own investment decisions. If you could divide 100 points among those three emotions to indicate how much each one affects your investments, how would you rate yourself?

In my own case, I’m basically “an aggressive chicken.” I think I would assign 60 points to fear, 30 points to greed and 10 percent to pride. That could explain why I rely so heavily on defensive market timing to protect me from big losses. If I had no greed but only fear, I could simply put my assets into money-market funds, T-bills and bonds – and enjoy all the safety. Finally, I have a little bit of pride, and I like to think that my investments will sometimes beat the market. When that happens, I feel good. But I know that feeling good isn’t my objective, and I don’t let that feeling tempt me to change my investment decisions.

If I applied this test to my former client, the one who couldn’t stand to lose almost $1,000 out of $125,000 he had invested to boost the performance of his $1.7 million portfolio, I would have to say that I initially thought he had at least 10 or 20 percent greed. But his actions indicated that his greed was probably no more than 5 percent, and it was totally overwhelmed by fear.

Another client story

Risk involves losses, and losses are not always what they seem. I recall one of my clients once asked me to talk to his father, who had invested $35,000 in a commodities pool. The father had a good income and a reasonably good portfolio of mutual funds. He was convinced, at least at the outset, that he could afford to lose the entire $35,000. When he asked for my advice, his “investment” in the commodities pool was down to $23,000, and he wasn’t sure he wanted to lose the rest of that money.

I asked him if he thought he was likely to live for at least another 20 years, and he said yes, of course. So I told him his choice wasn’t about losing his $23,000. I told him he should consider that he could lose not only the $23,000, but all the money he could make investing that $23,000 over the next 20 years. If he earned a compound rate of return of 12 percent for 20 years, that $23,000 could grow to $222,000. He hadn’t thought of it that way, and he suddenly saw the risk he was taking in a new light.

Eventually, most investors have to face up to the fact that they are taking risks. We have written about this topic many times, and I’d like to return to some things I said in a letter to clients in April 2000, just after the market had reached its peak and started downward. Like many other investors, some of our clients were asking what they should do.

We told our clients:

“The correct answer is very short: Develop a good strategy and follow it. You hired us to help you do that, and that’s what we’re doing. … On their Web site, our friends over at Safeco Mutual Funds recently summed up the current situation very well in a few words: “Trying to get rich quick is dangerous business. So is giving up too easily.” If you follow the advice implied by those sentences, you will be on the right track.”

We reminded our clients that the euphoria of 1999 and early 2000 had led many investors to conclude that caution “was an outdated concept they could afford to ignore”. Some investors had been stunned to discover that technology stocks, which had come to be treated as sacred objects in certain circles, could drop 30 percent or more in just a few weeks.

We said:

“Technology is profoundly changing the world in which we live. And it has produced some spectacular investment opportunities in the past decade. But technology has not repealed the basic rules of successful investing. One rule that has not been repealed is diversification. Investors who properly diversify do not have to worry very much about short-term changes in a single sector.

“Another rule still in effect is that if you want to be a successful investor, it is mandatory to persevere in periods like these. I’ve worked hard to make sure all our clients understand that, but I fear some people perhaps don’t want to hear it. So let me say it another way: If you can’t successfully get through periods like this, you have little chance of being a successful long-term investor.”

An excellent way to manage the emotional side of investing is to focus on appropriate time periods. Some people seem to think that long-term investing means waiting three weeks to decide if they made a good choice in mutual funds or stocks. Others are anxious if an investment doesn’t go up the day after they bought it.

So here are two quick tips about time and investing: If you will need to withdraw money for something like a down payment on a house or college tuition within the next 12 months, get that money out of the stock market. If your goal is achieving results in five years or 10 or 20, don’t measure and judge your success every day, every week, every month or even every quarter. Judge your performance over a period longer than a single year.

The longer you have before you’ll need to use your money, the less you need to be concerned about what’s happening to it this very day. If you own a home and you aren’t on the verge of selling it, you understand that daily or weekly or monthly changes in the market value don’t mean much to you. See if you can adopt the same attitude about your investments.

For investors in aggressive strategies, the two most effective ways to manage risk are to limit your aggressive exposure to a small part of the whole portfolio and to stick with your program once you have embarked on it. That is harder than it seems, as most investors learn when the market surprises them.

Typical behavior indicates that most investors either don’t understand risk or choose to ignore it. Here’s how I know that: When the market is rising, money floods in to stocks and mutual funds, even as each upward move in price increases risk and reduces potential returns. In a bear market, many investors engage in near-panic selling, even though each drop in price decreases risk and increases potential returns.

Nothing I write here will change that overall behavior. But if you can notice when you as an individual start to fall into this common trap, you may be able to short-circuit your tendency to engage in counter-productive buying and selling.

How much risk should you take? That remains the ultimate question.

People who get in trouble with risk are likely to be those who either take too much risk or who take too little risk. In an article we published last year called “How to Avoid the Worst Mistakes Investors Make”, we listed 18 common boo-boos. No. 3 was “Taking too much risk.” No. 4 was “Taking too little risk.” But we have never identified “Taking a moderate level of risk” as a potential mistake.

Whatever you do, find a comfort level that lets you sleep at night. In very general terms, take more risk when you’re younger and less when you’re older. Unless you’re sure you have more money than you’ll ever need, don’t completely avoid risks; instead, take calculated risks and manage them.

The answer

I think the ultimate answer is to get professional guidance from an investment advisor.

Many investors don’t want to discuss investment risks. They’d much rather focus on how much money they hope to make. Most of the investment industry is happy to give only token attention to risk and to encourage investors to focus on the good times.

The trouble is, it’s easy to succeed as an investor during good times, just as it’s easy for a football player to make a touchdown if there’s no opposing team. But in real life, there’s always an opposing team. If you don’t know how to deal with opposing players rushing at you, your touchdowns will be rare or nonexistent.

Similarly, if investors aren’t prepared for bear markets, their chances of success are severely handicapped. An investment professional can prepare you for facing investment risks in a methodical way.

We start that process by asking prospective clients to complete a five-page Confidential Investor Information Form which includes several questions that give us insight into the risk tolerance of the person filling out the sheet.

We sometimes get our first clue from the answer to “Do you and your spouse/partner generally agree on your financial goals?” We ask the person to list his or her financial goals and the approximate time remaining until the money will be needed for each goal. That’s a big help in figuring out what’s an appropriate risk. The right investments for money being saved for a house down payment or college tuition in two years are very different from the right investments to fund a retirement 20 years in the future.

Then we ask three pointed questions related to risk:

We also ask investors to list past investments that have pleased them and displeased them and to tell us why they were pleased or displeased. Sometimes this gives us more useful information.

The final page of the information sheet is the Risk Tolerance Quiz, which consists of five multiple-choice questions designed to help investors think about their objectives and the risks that go with them. In what may be an understatement, we say: “This is not a precise science and there are no right or wrong answers.” Here are the questions:

What we’re looking for are patterns and consistencies or inconsistencies that will suggest things we should discuss with the client when we open an account. The work we do at this stage helps us keep clients on track later.

A great coach stays on the sidelines and can see things the players can’t. Likewise, a great advisor can keep investors focused on what matters.

Earlier I quoted a letter to clients saying the real job of investors is to manage risk and manage emotions. As we have seen, there’s no clear line between them. Because this is difficult territory, many investors avoid it, focusing instead on their rosy hopes.

It’s fine to hope for the best. But if you also plan for the worst – and if you spend some time getting comfortable with the topic of risk – you’ll greatly increase your chances of being a successful investor who can sleep at night.

 

 

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