Tuesday, October 13, 2009

Understanding Risk - The Risk of Too Little Risk

Last week, on the radio show I appear on as a regular guest, I suggested that instead of trying to determine what your risk tolerance was, you should instead think about what makes you anxious. This anxiety tolerance takes a more introspective view of who you are rather than what your investments might be doing. It requires, among other things, that you turn off the media.

Streaming into your living room is an after-the-fact representation of what the markets are doing. Even real time reports are not so much real time as a tool for edgy traders to plot their next move. If you really care about what your retirement accounts are doing, in terms of what they will provide ten, twenty or even thirty years down the road, looking at this type of data will force to re-examine what you may have previously thought was a good idea.

Although there is a science to investing, it is far less competent at coaxing the truth or any sort of conclusion fro the available data. The markets, pushed by human emotion (even if it is pre-programmed into a computer via modeling) fail to give you a true perspective, something that you would consider concrete, undeniable and/or truthful. This sort of representation is enough to make even the most savvy investor squeamish.

The knee-jerk reaction, the one a vast majority of investors are considering or have already begun is a move back to less risk. As banks fail, as markets gyrate, and as the recovery, albeit jobless, begins, some basic things should be kept, not in the back of your mind, but in the forefront.

No risk means saving. This is the traditional approach to keeping your money close at hand, for emergencies. It comes with risk as well. There is the inflation risk. Currently at or around zero, inflation strips the value of your dollar by making it worth less in the future. Without the interest that savings provides, each dollar saved will have less buying power. In an inflationary environment, that interest paid to you must beat inflation (even if you use the historic reference point of 3.5%).

And it must beat taxes. These will always rise, if not right up front, the increases will be felt through the products we buy, the business we conduct or the income we earn. No risk, in other words, has some risk and it is mostly on the downside. (That doesn't mean should abandon the emergency funds you are currently funding or stop you from getting one started.)

Your anxiety (or risk) tolerance may be forcing you to look for investments in your retirement accounts that take more risk than is desirable. Before we look at those types of investments, it is important to note that the reason you invest in your 401(k) is to provide income for a time when you no longer want to work (or work doing what you are doing).

For many of you, this has meant turning to the ever-present and often innocuous retirement calculator online. You enter into these tools, your current balance, which according to the latest Employee Benefits Research Institute report, is about $74,148 for the average 40 year-old. (The study reports data as of the year ending 2008.) While this down over 25% from the close of 2007, that figure represents a 35% increase for the investor in this age group since 2003.

The report also indicates that this was in-line with the stock markets performance over the same period. If you suffered less, it was due to diversification and the ability of the 401(k) to supply ongoing and consistent investment. This diversification was found using equity investments as the primary driver for the growth in these portfolios. In terms of asset allocation, 40% of this group allocated 80% or more of their assets to the equity markets, down only slightly from their years as a twenty-year old. (This group also owned about 11% of the remaining portion of their portfolios in their own company's stock.

These contributions are, as one might expect, greater in your investment youth. Or they should be. Investment returns (and sometimes losses) are the result of many of the changes in portfolio valuations. Even after the losses experienced in this age group's portfolios (28.5% in 2007-2008 and 5.8% in 2001-2002) the average account over a ten year period had increased 94%.

I have suggested that you should contribute at least 5%, company match or not. If you begin with that average balance of $74k, in 25 years you will have breached the $250,000 mark using a conservative approach which has about 50% of your portfolio invested in equities. Reduce your exposure to bonds in that portfolio to 15% or less, and the same time span could leave you with a balance of four times as much.

In terms of risk, 2008 was a game-changer. While 64.5% of those with plans in 1998 found equities the most desirable of investments, by 2008 this sentiment had shifted to 41.9% with the shift to a more balanced approach such as lifecycle funds (an increase of over 300% and to bond funds, which posted a 100% increase from a decade ago. Although we are looking at the forty year-olds, the sixty year olds made essentially the same moves as their counterparts twenty years their junior.

Using a retirement calculator, based on a generous 5% withdrawal when you retire, at age 40 or younger, will not produce the retirement income (based on a growth rate of 8% after you retire, beginning with zero and ending with a balance of $250,000 and an inflation rate of a modest 3.5%) you might imagine. If you can live on $14,446 in the first year (excluding Social Security and if you are fortunate enough, pension payments) then you are on track. This will however, draw your balance to zero in thirty years or less, if your investments fail to meet the 8% mark, year over year.

2008 also brought a dramatic increase in the number of loans on these plans (90% offer some sort of loan available). Eighteen percent of you tapped these provisions with, the report cites, an average outstanding balance of $7100. This may have been money you thought you needed at the time. But what it represents has a far greater impact in the future.

So why are so many individuals shifting to a less riskier (less anxiety inducing) form of investment? Perhaps they simply do not know what they are setting themselves up for in twenty or more years.

There is the argument that these more conservative investments utilized by retirement investors are not as risk free as previously imagined. This could put an additional drag on perceived outcomes you and your calculator have projected.

All bonds, essentially an extension of credit are compared to what the US Treasury issues. The difference between what a bond yields against this measure suggests the creditworthiness of the bond. In other words, the closer the bond to the US Treasury, the safer it is.

And as we say safe, we also remind you what we have previously discussed about safety. Without some risk, the chances that your money will grow are greatly diminished.

While this complicates the purchase of a bond individually, it makes bond funds much more attractive and some respects, slightly more risky. And in lifecycle funds, the employment of bonds lowers the risk of too much equity while possibly increasing risk where safety is sought.

What if, as Eric Fry of the Daily Reckoning suggests, the creditworthiness of the US Treasury comes under pressure? It is extremely important to bonds that it have a good benchmark to use. He writes: "Are foreign sovereign issuers becoming MORE credit-worthy or is the US government becoming LESS credit-worthy? Or is it a little bit of both?"

This type of risk may undermine the best intentions of the retirement investor and those who invest for them from a direction they will be mostly unprepared to handle. Not only will the return they are seeking be less than than they need to get to where they are going, there is a possible risk that they will receive far less than they anticipated. Fixed income may not be so fixed.

There is a risk to the equity markets because of this possibility. Yet it is still one worth taking. Even if your anxiety tolerance will not let you go beyond the simplicity of an index fund, you will fair better over the long run that those who shift gradually to a more balanced approach with an increasing amount of bond type investments. I'm not adverse to adding to your portfolio a fund that offers even more diversity (even a conservative choice) but in many instances, investors simply reallocate existing contributions when they should, for the best possible balance, increase their contribution and direct these increases to the more conservative product.

There is a distinct possibility that too little risk will not perform as planned.

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