Hugh F. Doherty, DDS, CFP
According to Ibbotson Associates, between 1990 and 1999 the stock market compounded at a dazzling 18 percent annual rate, compared with the historical 75-year average of 11 percent. Despite this statistic, investors exposed themselves to enormous risk to achieve those returns. Review the recent NASDAQ corrections and the broader market swings as a wake-up call. Risk is alive and well.
How to assess risk
Investment risk is defined as variability of return. But most investors are more concerned about the risk of loss. Generally, the higher the risk of a security, the higher the average return of that security ... and the higher the potential for loss. Several yardsticks can help compare the risk of securities or mutual funds. Information is available free on the Internet. My favorites are http://finance.yahoo. com and www.morningstar.com.
- Beta measures volatility - how much the price of a security moves relative to a specific benchmark, typically the Standard & Poor`s 500 Index. Example: The large-cap growth mutual fund Janus Twenty (JAVLX) has a beta of 1.17 - meaning it is 17 percent more volatile than the S&P 500 Index, which has a beta of 1.0.
- Standard deviation is a statistical measure. In investing, past performance typically determines the range of possible future returns for a security or a whole portfolio, relative to its own long-term average. The higher the risk, the higher the standard deviation. Example: A utility stock might have an annual standard deviation of 20 percent, while a technology stock might have a 60 percent standard deviation.
How to manage risk
(1) Be honest about your own "good night`s sleep threshold." That is the risk level you can tolerate without making rash decisions or abandoning your disciplined investment plan. Factor in your financial situation and emotional temperament. Most doctors overestimate the amount of risk with which they feel comfortable.
(2) Determine your time horizon. The more time you have, the more risk you can take ... and the higher your potential return. If you will need access to your money in one to four years, don`t invest in securities.
(3) Diversify investments. Asset classes do not move in tandem. Include in your portfolio high-risk assets, along with low-risk assets - such as tax-free municipal bonds, inflation-indexed government bonds, and money-market accounts. A decline in one category can be minimized by an increase in another.
(4) Don`t assume all bonds are low-risk. It depends greatly on the type of bond, its credit quality, and duration. Prices can fluctuate dramatically with changes in rates.
(5) Diversify within each category; i.e., growth vs. value stocks. Growth stocks have price-to-earnings ratios (P/E`s) higher than the S&P 500 average. Value stocks have lower average P/E`s. Split your investments with a slight bias toward value (say, 55 percent value and 45 percent growth). Long-term studies show that value stocks slightly outperform growth stocks.
(6) Large- and small-cap stocks. The largest 500 companies represent about 70 percent of the capitalization of the stock market; the other companies make up 30 percent. Match those percentages in your portfolio or invest in index funds.
(7) International vs. U.S. stocks. While foreign companies account for 50 percent of the global market, American investors should invest mainly in the U.S. The reason: Currency fluctuations can amplify or erase gains in a foreign stock. Invest about 15 to 20 percent of your stock allocation in foreign companies to reduce portfolio risk. Did you know that owning stock in American multinational companies - such as Coca-Cola or McDonald`s - gives investors significant international exposure? Foreign equities provide diversification, but the effect will decrease over the next two decades with the continued globalization of markets.
Hugh F. Doherty, DDS, CFP, is a Certified Financial Planner, national lecturer, financial adviser to the health-care profession, and CEO of Doctor`s Financial Network. For further information on lectures, study club workshops, or consultations, you can fax to (732) 449-3229, send e-mail to email@example.com, call (800) 544-9653, or visit www.hughdoherty.com.