Determining Your Risk Tolerance—Section 9
In determining your ability to assume risk, you must first define what types of risks that you are willing to accept. If you are investing in mutual funds, you are already limiting your exposure to asystemic risk. (see section 3). You are still, however, subject to several types of systemic risks including inflation risk, interest rate risk and, above all, market risk.
One way of dealing with the effects of inflation is to invest a portion of your retirement savings in stock based mutual funds. Although the stock market is subject to wide and sometimes violent price swings, the overall trend has been up.
This is because as the U.S. and world economy continues to grow, more wealth is created in the form of productive assets such as factories, new technologies, and increased knowledge. For the most part, these productive assets are owned by publicly traded corporations. The increasing wealth of these corporations is reflected in higher stock prices.
There is, of course, no guarantee that the economic conditions that produced the long term upward trend of the U.S. Stock Market will always be present. As long as they do, however, it is likely that this upward trend will continue.
Interest rate risk can be reduced by investing in short maturity bonds but this means sacrificing return. A balance between risk and return can be obtained through the creation of a laddered bond portfolio using a combination of short, intermediate and long term bond funds (see section 7 and section 8).
The most serious risk faced by mutual fund investors is market risk. During a bear market virtually all stock based mutual funds will lose money and sometimes a lot of it. Anyone in the market between 2000 and 2003 will attest to that. It can take a very long time to recover from a severe market loss. For example, if you bought the Dow Jones Industrial Average in 1929, you would have had to wait until the early 1950s to completely recoup your losses.
When determining your ability to assume market risk, you need to consider how much you could lose and for how long before you suffered a financial hardship or the emotional pain became unbearable. Factors that need to be examined include the time until the money will be needed, the type and extent of other assets, the amount of money involved and your temperament.
The stock market moves in cycles from bull market highs to bear market lows and back again. You don’t want to be in the position of having to liquidate assets to meet living expenses when the market is at a low. To avoid this, you must invest according to your time horizon. Your time horizon is determined by when the money will be needed. This can be long before or long after your anticipated retirement date. For example, if there is a possibility that you will need the money in your retirement account to pay for a child’s education in two years, your time horizon is two years, even though you don’t plan on retiring for another 15 years. If, on the other hand, you are going to retire next year but won’t need your retirement money for another 10 years, your time horizon is 10 years, not one.
As your time horizon shrinks, your ability to assume market risk diminishes. You no longer have the time to wait out market cycles. This means that you need to gradually move from stock based investments to bonds and cash beginning 8 to 10 years prior to the time that the money will be needed. The timing of the reallocation process will depend on a number of factors including current market conditions. If the market is at an all time high, it may be prudent to take more money off the table sooner. If the market is depressed, the process can be slowed down in anticipation of a recovery.
The extent and type of your other assets is also a factor in determining your ability to assume market risk. If you have $500,000 in the bank and $200,000 in your retirement plan, you can obviously be more aggressive with your retirement money because it represents a smaller portion of your total worth than if your retirement account was your only liquid asset. If all of your other savings are invested in stocks, it also may be prudent to allocate your retirement savings more towards bonds in order to achieve an overall balance.
You should also consider the amount of money involved. Losing money hurts and losing a lot of money hurts a lot more. For example, if you have $200,000 invested in stock based mutual funds and the market declined by 25%, which doesn’t even constitute a particularly severe bear market, you could be looking at a $50,000 loss. Would you be able to take this loss calmly and patiently and wait for the market to recover or would the emotional pain become so great that you liquidate your stock based investments to simply stop the bleeding?
The emotional component of investing should not be underestimated. If you are investing in the stock market through mutual funds, at some point you will experience a substantial but, probably temporary loss. You need to consider how this will affect you emotionally and to prepare yourself in advance for this eventuality.
A few people are temperamentally unsuited to assume the risks associated with stock based investments. They lose sleep over even the possibility of a loss. My advice to these people is to stay away from stock based investments entirely. It is not worth the aggravation. Choose a low risk investment, such as a short maturity U.S. government bond fund, accept the lower return and compensate for it through increased savings.
Quiz —Section 9
1.All types of risk pose the same danger to your financial well being.
A) True
B) False
2.Although the U.S. stock market is subject to wide price swings, the long term historical trend has been:
A) Up
B) Down
C) Sideways
3.The most serious risk faced by people investing in stock based mutual funds is:
A) Business risk
B) Credit risk
C) Market risk
4.During a bear market, most stock based mutual funds will:
A) Stay the same
B) Make money
C) Lose money
5.Your time horizon is determined by:
A) The time until you plan to retire
B) The time until you are eligible for social security benefits
C) The time until the money in your account will be needed
6.As you approach the time when the money in your retirement account will be needed. Your ability to assume market risk:
A) Increases
B) Decreases
C) Stays the same
7.The emotional impact of investment losses should be:
A) Ignored
B) Considered and prepared for
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