How much risk can you afford?
Nine out of ten investors, when asked how much risk they are willing to take respond with one version or another of “as little as possible”. That is the way I think, and I’m guessing you think that way too.
Let’s face it, losing money is unpleasant. This is why risk avoidance is my number 1 priority in managing your money. Avoiding losses allow gains to come much more easily.
Consider the average S&P 500 index investor who lost 48% of their money in the 2000-02 market decline. One million dollars became $520,000 in a two year period. For that portfolio to then produce income of $60,000 per year it would need to earn over 11.5% per year to avoid eroding the remaining principal. By avoiding that initial loss, our portfolio only needs to earn 6% to produce a $60,000 income. Believe me, 6% is a lot easier to achieve year in and year out than 11.5%. This is the secret to the way I invest your money at Hepburn Capital.
Every new client relationship begins with a series of questions designed to help me identify that individual’s tolerance for risk. What is unusual is that your attitudes toward risk will change, sometimes depending on how you feel that day. Accurately assessing your risk tolerance is much more art than science.
My friend Roger Schreiner, of Schreiner Capital Management in Exton, PA, astutely pointed out to me that for a typical investor once their risk tolerance level has been identified, sadly, many brokers and financial planners recommend investments designed to encounter the maximum level of risk indicated. The reasoning is that this way they can also pursue the greatest reward their risk tolerance allows.
But I disagree. Investment risk is not something that we have a maximum tolerance for and try to experience. Risk is something we begrudgingly accept only because the consequences of avoiding risk altogether (burying your money in the back yard) can be more painful in the long run. Risk needs to be managed and minimized.
Anyone who understands the math of gains and losses described in my million dollar example, above, can see what I mean. I think taking lower risk often leads to higher rewards, with a lot less heartburn along the way.
Although there is no perfect way to ask “what is your risk tolerance” I am not going to quit asking. Only through experience can I confidently place your money in the investment strategy that is most appropriate for you. For this reason, if anything makes you uncomfortable about your accounts, please let me know promptly so adjustments can be made.
Will Hepburn is a well known expert on investment analysis and portfolio management. In addition to publishing the Financial Market Review, Mr. Hepburn is president of Hepburn Capital Management, LLC, a Registered Investment Advisor, a director of NAAIM, the National Association of Active Investment Managers, and he is an instructor at Yavapai College in Prescott, AZ. 7/17/2007