Investors Must Recall Risk Investing's Four-Letter Word

The Wall Street Journal Interactive Edition -- January 23, 1998
Investors Must Recall Risk, Investing's Four-Letter Word
By KAREN HUBE Staff Reporter of THE WALL STREET JOURNAL
What four letter word should pop into mind when the stock market takes a harrowing
nose dive? No, not those. R-I-S-K. Risk is the potential for realizing low returns or even
losing money, possibly preventing you from meeting important objectives, like sending
your kids to the college of their choice or having the retirement lifestyle you crave. But
many financial advisers and other experts say that these days investors aren't taking the
idea of risk as seriously as they should, and they are overexposing themselves to stocks.
"The market has been so good for years that investors no longer believe there's risk in
investing," says Gary Schatsky, a financial adviser in New York. "And when the market
drops hundreds of points and rebounds immediately, that belief is confirmed." The
danger is that when the market declines and stays down for months -- as some analysts
predict it eventually will -- investors won't be able to meet their short-term financial
goals. Or, they will panic and sell their investments as their shares are declining in value,
which is the worst possible time. So before the market goes down and stays down, be
sure that you understand your tolerance for risk and that your portfolio is designed to
match it. Assessing your risk tolerance, however, can be tricky. You must consider not
only how much risk you can afford to take but also how much risk you can stand to take.
What you can afford depends mainly on your time horizon -- how long before you will
need the money. If your investments are targeted for your child's college tuition in three
years, for instance, your financial ability to take on risk is low because you may not have
time to recover if the value of your portfolio declines. But if you have 10 years before
your child heads to college, you can afford to take more risks because you would have
plenty of time to ride out dips in the market. Determining how much risk you can stand --
your temperamental tolerance for risk -- is more difficult. It isn't quantifiable. "A variety
of behavioral factors come into play," says Richard Bernstein, director of quantitative
research at Merrill Lynch & Co. in New York. "If my broker asks me if I want high-risk
or low-risk securities, I may say high risk because I don't want to look wimpy." Similarly,
some people will gloss over the less impressive details of their investing histories, says
Ronald Roge, a financial adviser in Bohemia, N.Y. He routinely asks to see copies of his
clients' tax returns to get a reliable account of gains or losses. "The aim is always to find
the fine line between greed and fear," he says. To that end, many financial advisers,
brokerage firms and mutual-fund companies have created risk quizzes to help people
determine whether they are conservative, moderate or aggressive investors. Some firms
that offer such quizzes include Merrill Lynch, T. Rowe Price Associates Inc., Baltimore,
Zurich Group Inc.'s Scudder Kemper Investments Inc. of New York, and Vanguard
Group in Malvern, Pa. "The typical investor may not have ever experienced a negative
turn in the stock market. They need to be prepared for that," says Robert Benish, vice
president of education programs for Scudder, whose questionnaire is part of a broader
investing-education program. "We want to help them understand what risk means to
them." Typically, risk questionnaires include seven to 10 questions about a person's
investing experience, financial security and tendency to make risky or conservative
choices. Some of these risk tests, such as one created by Vanguard (www.vanguard.com),
can be found on-line. The benefit of the questionnaires is that they are an objective

esource people can use to get at least a rough idea of their risk tolerance. "It's impossible
for someone to assess their risk tolerance alone," says Mr. Bernstein. "I may say I don't
like risk, yet will take more risk than the average person." Many experts warn, however,
that the questionnaires should be used simply as a first step to assessing risk tolerance.
"They are not precise," says Ron Meier, a certified public accountant who teaches
investing-related courses at the College for Financial Planning in Denver, a unit of
Apollo Group Inc., Phoenix. "They are good for leading discussions but not for coming
up with a final risk score." The second step, many experts agree, is to ask yourself some
difficult questions, such as: How much you can stand to lose over the long term? "Most
people can stand to lose a heck of a lot temporarily," says Mr. Schatsky. The real acid
test, he says, is how much of your portfolio's value you can stand to lose over months or
years. Rather than using percentages, think in dollar terms. "When you convert
percentages to figures, often you see very different psychological effects," says Richard
Wagener, a financial adviser in Columbia, Md. The idea of a 20% decline on, say, a
$150,000 portfolio is more abstract than a $30,000 loss, he says. Financial adviser Glen
Clemans of Portland, Ore., says he cites the 1972-1974 bear market to help his clients
realize how much they can lose. "I tell my clients to imagine they had put $100,000 in the
S&P 500 in November 1972," says Mr. Clemans. He then explains that after the first
year, the investment would have been worth $88,000. "I watch to see how they flinch.
Then I tell them that the next year, their investment would have been worth $67,000, and
ask them 'So now what would you do?' " As it turns out, most people rank as middle-ofthe-road
risk-takers, say Mr. Clemans and other advisers. "Only about 10% to 15% of my
clients are aggressive," says Mr. Roge. For some of the biggest risk-takers, particularly
those who say they like to gamble, Mr. Roge recommends creating an "action account"
that includes no more than 10% of their assets. Money in the account can be used to
speculate in the stock market. "Some investors just love the excitement of getting a stock
pick from a brother-in-law, even though they may lose money," says Mr. Roge. "People
who need that kind of action should have an outlet for it."
Copyright ©1998 Dow Jones & Company, Inc. All Rights Reserved.
Questions
1. "Risk is the potential for realizing low returns or even losing money, possibly preventing
you from meeting important objectives, like sending your kids to the college of their
choice or having the retirement lifestyle you crave." Do you agree with this definition of
risk?
2. Mr. Roge, who is quoted in this article, mentions a simple test of risk tolerance. (Use the
1972 to 1974 experience) Do you think this is a reasonable test? Why or why not?
3. What are some of the factors that this article suggests determine your risk tolerance? Do
you agree? Explain.

Judging Your Own Tolerance For
Investment Risk
by George Paniculam
Think about these two questions:
1. If you had a 100 percent chance of winning $8,000 or an 80 percent chance of
winning $10,000, which would you choose?
2. If you had a 100 percent chance of losing $8,000 or an 80 percent chance of
losing $10,000 and a 20 percent chance of losing nothing, which would you choose?
Think about it. This is a test, and we'll come back to it in a minute. In the meantime,
let's discuss investment risk. That's an important question because one of these days
the stock market is going to quit setting record highs and fall back for a while. By
how far and for how long is anybody's guess.
What is known is that the Dow has not suffered a 10 percent "correction" since 1990.
That's a long time. A 10 percent correction in today's market would be roughly 700
points. Many investors in today's market have never seen a 10 percent correction.
What would you do if the market dropped 700 points -- or more? Panic and sell?
Take a deep breath and buy? Hold tight?
What would you do if we have a repeat of the 1973-74 bear market when stocks lost
45 percent of their value in just under two years? Could you weather that?
These questions are really variations of a single question: What is your tolerance for
investment risk?
First, of course, you need to define risk. All investments have risk. Even certificates
of deposit have risk -- they generally won't lose the money you put in them because
they're government insured, but they can earn less than what taxes and inflation eat
away. Stocks usually stay ahead of taxes and inflation, but there is always the shortterm
risk of loss of principal. So what is investment risk to you: loss of principal,
inability to maintain a standard of living, failure to meet the investment goals you
set?
Now back to our opening question. Studies have shown that most people choose the
100 percent chance in question 1 and the 80 percent chance in question 2. In other
words, they hate loss more than they love gain -- even though the alternative
choices in both questions are actually superior risks.
One financial planning firm likes to ask clients the following: "Would you rather be
out of the stock market when it goes down than in the market when it goes up -- or
vice versa?" The question really goes to the heart of whether one should be in the
stock market at all, since to be in the market when it goes up usually means you
have to be in the market when it goes down. If one can't stomach that, then one
should not be in the stock market.
Of course, determining what you will really do when the market drops is tough. It's
easier to be brave when the market is soaring than when it is dropping. One guide is
to ask yourself what you've done in the past, through either minor or major (if you

go back that far) market downturns, or what you've done when a particular
investment dipped. Did you sell, hold, buy? Financial planners suggest these tips to
help you weather the storms when they come:
• Diversify your portfolio. That way, if the domestic stock market drops, the
other parts of your portfolio might cushion the overall fall and keep you from
panic selling.
• Focus on the overall portfolio, not just one part. At any given time, some part
or parts of your portfolio won't be doing as well as another part. Some parts
may even be losing. That's the nature of a well-balanced portfolio.
• Know your goals. If you're investing for retirement 20 years away, who cares
what the market does today. If you're investing for college two years away,
think about reducing your riskier investments.
• Be informed. Panic selling often stems from ignorance. The more you know
about investing and how markets go up and down, the less nervous you'll be.
• Expect surprises.
This column is produced by the Institute of Certified Financial Planners and is
provided by George Paniculam, MBA,CFP, a local member in good standing. He can
be reached at 410-461-2411.

4. I understand the value of my portfolio will fluctuate over time. However, the maximum loss in
any one-year period that I would be prepared to accept is approximately:
(A) O%
(B) -5%
(C) -10%
(D) -20%
(E) -30%
5. Consider the following two investments, A and B. Investment A provides an average annual
return of 5% with minimal risk of loss of principal. Investment B provides an average annual
return of 10% but carries a potential loss of principal of 20% or more in any year. If I could choose
to invest between investment A and Investment B to meet my goal(s), I would invest my money:
(A) 100% in Investment A and 0% in Investment B.
(B) 80% in Investment A and 20% in Investment B.
(C) 50% in Investment A and 50% in Investment B.
(D) 20% in Investment A and 80% in Investment B.
(E) 0% in Investment A and 100% in Investment B.
6. The data below represent actual historical performance of four selected investment portfolios,
A, B, C and D, over a 60-year period. The chart illustrates average annual total returns.* This
performance must be weighed against the associated risk reflected in the high and low range of
annual returns experienced by the portfolios. These ranges are displayed below the chart. (For
example, Portfolio C achieved a 12.20% average annual total return during the 60-year period,
gaining 54% in the best year and losing 43% in the worst year.) Among these investments, I
would prefer my primary investment to be:
(A) Portfolio A (B) Portfolio B (C) Portfolio C (D) Portfolio D

SCORING
After answering each of the six questions, use the following point system and grid to total your
score.
RESULTS
In general, the higher your score, the more comfortable you would appear to be with taking on
financial risk. Two things should be kept in mind as you read the descriptions of the various risk
profiles on the following page. First, your recent investment experience may have influenced your
responses. Recent success may bias you toward taking on more risk, while recent setbacks may
incline you toward a more conservative approach. Second, in the category indicated by your
score, you may find that the attainment of your goals would be difficult. You should discuss such
matters with your Merrill Lynch Financial Consultant.
RISK CATEGORY 1
(6-15)
CONSERVATIVE: In this risk category, preservation of capital is the single most important
concern, with an average annual total return typically ranging from 5% to 7%. Adjusted for
inflation, investment returns may be very low or, in some years, negative, in exchange for very
high liquidity and essentially no risk of principal loss.
RISK CATEGORY 2
(16-25 points)
CONSERVATIVE to MODERATE: In this risk category, preservation of capital and income are
the most important objectives, with an average annual total return typically ranging from 6% to
8%. A slightly greater willingness to accept risk is seen in a desire to have a modest positive
"real" (after-inflation) rate of return.
RISK CATEGORY 3
(26-34 points)
MODERATE: Investors in this risk category accept possible principal loss as a natural function of
investment risk incurred in the pursuit of higher total return, typically ranging from 7% to 9%. The
degree of risk is normally reduced through diversification and asset allocation and periodic
revisions to rebalance any excesses that develop.

RISK CATEGORY 4
(35-44 points)
MODERATE TO AGGRESSIVE: Investors in this risk category are yet more willing to take risk,
both in the types of securities held and in the concentration of holdings in favored market sectors.
The average annual total return typically ranges from 8% to 10%, but some holdings may be
aimed at higher goals. More active portfolio adjustment is a typical feature of this type of
investor's behavior.
RISK CATEGORY 5
(45-54 points)
AGGRESSIVE: Investors in this risk category typically are willing to sustain more in the way of
losses on individual transactions in expectation that overall portfolio results in the balance of their
holdings will produce average annual total returns of 10% or greater. More concentrated positions
and frequent portfolio changes typify this type of investor. More speculative investment choices
also require careful and continuous oversight. Investors in this category may experience a wide
variance in results from one year to the next in the pursuit of longer-term goals.

Investment Risk
Knowing Your Limits
Personal Finance Advisor by Deloitte & Touche LLP
Updated July 29, 1996
By Tom Myers
Deloitte & Touche LLP Senior Tax Manager
The stock market and individual stocks have been experiencing unprecedented volatility
this year. In fact, four of the five largest one-day declines in the history of the Dow Jones
Industrial Average have occurred this year. This coming on the heels numerous record
highs and an impressive 38% increase in 1995.
Naturally, the market's slide has many investors concerned. Understanding investment
risks can help you cope with this volatility.
Setting the Stage: An evaluation of investment risk must consider the investor's overall
financial goals. Thus, the first step is to identify financial goals -- what, how much, and
when -- and list them in order of importance. Once the reasons for investing are identified
and prioritized, then it is time to think about the amount of investment risk the investor is
comfortable assuming.

Types of Risk: Assessing risk involves knowing both the various types of investment
risk and the investor's tolerance to assuming these risks. The following are brief
descriptions of the most common types of risk investors face.
Investment
Risk
Market Risk
Company Risk
Credit Risk
Interest Rate
Risk
Inflationary
Risk
Reinvestment
Risk
Industry Risk
Currency Risk
Definition
The uncertainty due to changes in the general level of market prices for
investments, caused by political, social, and/or economic changes.
The uncertainty that a particular company may fail to meet future earnings
expectations, be unable to pay dividends or interest, or succumb to the
competition.
The risk that a company, agency, or municipality may experience difficulty in
paying its debts.
The risk that interest rates may rise and decrease the value of an investment.
The uncertainty that investments will not keep pace with inflation and
purchasing power will be reduced.
The uncertainty that the investor will not be able to reinvest the earnings
and/or principal at the same rate of return that the initial investment earned.
The uncertainty that a particular industry's performance may impact the
growth of the investment.
The uncertainty that currency fluctuations may affect the value of foreign
investments or profits when converting them into the investor's local currency.
Risk Tolerance: Personal feelings about investing impact all investment decisions.
Ultimately, an individual investor's tolerance to risk will determine the boundaries for
appropriate investments. There is no right or wrong personal risk tolerance, but
investments should never cause you to loose sleep.
Risk Versus Return: Most investors prefer certainty over uncertainty. As rates of return
become more uncertain, investors expect higher returns. There can be up to components
to a rate of return: the risk-free rate of return (for example, U.S. Treasury bills or T-bills),
the premium over the risk-free rate of return to offset inflation risk, and the premium for
a particular investment over the inflation-adjusted risk-free rate of return. The tradeoff
between risk and return is fundamental to all financial decisions, and consequently, to
implementing an investment strategy.
Importance of Time: The length of time that investments will be held is the single most
important factor in any financial plan. The following diagram illustrates the approximate
returns after inflation for stocks, bonds, and T-bills during this century, and demonstrates
the effect of time on historical investment returns.

Historical performance is never a guarantee of future results. Market history, however,
indicates:
• Volatility, or risk, of stocks decreases significantly over time.
• The return on equity securities exceeds the return on fixed income investments over long
periods.
• Investments that are appropriate for long-term financial goals are inappropriate if the
investment time frame is relatively short.
Diversification and Asset Allocation: The lack of diversification ("having all of your
eggs in one basket") can be a risky proposition. Many investors use mutual funds to
diversify their investments; however, having all investments in one type of mutual fund
(for instance, a stock fund) still exposes investors to the risks of that asset class.
Different categories of investments typically do not all perform well at the same time. For
example, stocks and bonds often react differently to the same economic or political news.
By spreading investments among various types of asset classes ("asset allocation"), a
portfolio is better prepared to handle the inevitable ups and downs of the markets.
Your financial and investment advisor can provide you with more information on an
appropriate investment risk and asset allocation strategy and should be consulted before
any action is taken.
Tom Myers is a senior tax manager at Deloitte & Touche, with 11 years experience
advising entrepreneurs and closely-held businesses on tax and business matters.

Understanding Your Risk Tolerance
Can Make You a Better Investor
OK, so you're tired of the single-digit returns on your bank
CD. You've found a mutual fund that gained an average 20
percent a year over the past five years.
Before you write that check, though, be sure to ask yourself
this question: "Do I have the risk tolerance to see this
investment through?"
Why? Because it's a general characteristic of investments:
The ones that earn more tend to fluctuate more in value.
You may have wonderful results one year and actually lose
money in another. If you want the high returns, you have to
put up with a bumpy ride.
Some people aren't cut out for that kind of thing. They bail
out of an investment at the first sign of trouble. That could
mean selling at the worst possible time. Know your limits
and you'll avoid that kind of trap.

This quiz will help you gauge your own risk tolerance.
Column 1 Column 2 Column 3
1. Which best
describes your feelings
about investing?
"Better
safe than
sorry."
"Moderation in
all things."
"Nothing
ventured, nothing
gained."
2. Which is most
important to you as an
investor?
Steady
income.
Steady income
and growth.
Rapid price
appreciation.
3. You won! Which
prize would you
select?
$4,000 in
cash.
A 50 percent
chance to win
$40,000.
A 20 percent
chance to win
$100,000.
4. The stocks in your
401[k] statement have
dropped 20 percent
since last quarter. The
market experts are
optimistic. What would
you do?
Transfer
out of
stocks to
avoid
losing
more.
Stay in stocks
and wait for
them to come
back.
Shift more money
into stocks. If they
made sense
before, they're a
bargain now.
5. The stocks in your
401[k] statement have
suddenly gone up 20
percent. You have no
further information.
What would you do?
Transfer
out of
stocks and
lock in my
gains.
Stay in stocks,
hoping for
more gains.
Transfer more
money into
stocks. They
might go higher.
6. Would you borrow
money to take
advantage of a good
investment
opportunity?
Never. Maybe. Yes.
How to determine your score
Each answer in Column 1 is worth one point.
Each answer in Column 2 is worth two points.
Each answer in Column 3 is worth three points.
Add them up to find your total score.
7-11 points: a conservative investor.
12-16 points: a moderate risk-taker.
17-21 points: an aggressive investor.
Information contained herein has been reprinted with the permission of
Standard & Poor's, a division of McGraw-Hill, Inc. The information
has been obtained by Standard & Poor's from sources believed to be
reliable. However, because of the possibility of human or mechanical
error by our sources, Standard & Poor's, AT&T RESOURCES for New

Business or others, AT&T RESOURCES for New Business does not
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and is not responsible for any errors or omissions or for the results
obtained from the use of such information. Reproduction in whole or in
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© 1995 by McGraw-Hill, Inc. All rights reserved.

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