Testing tolerance for risk is a must before investing

PERSONAL FINANCE

April 09, 2000|By Eileen Ambrose

Say what you will about last week's stock market plunge, it was a good test of investors' stomachs for risk.

With both the Nasdaq and Dow Jones industrial average hurtling down more than 500 points in just a few hours Tuesday, investors got an idea of whether they can handle the periodic white-knuckle market ride. The day, however, ended less dramatically, with the indexes regaining much lost ground.

Gauging your risk tolerance is one of the basic first steps of investing, but it's also one of the most difficult, financial experts say. It's been made even trickier in recent years because many investors have grown accustomed to a bull market that quickly recovers from even steep declines.

Investors today are more likely to say they lean toward an aggressive style than those a decade ago, financial advisers said.

"Many investors feel more confident in their ability or willingness to take risk when the markets are doing well," said Pat Burke, a principal with the Vanguard Group.

Indeed, when presented with sample portfolios based on different levels of risk, new clients often choose the most aggressive that also yield the greatest average annual return over the long haul, said Barry Glassman, a certified financial planner with Cassaday & Co. in McLean, Va. They don't realize that the average could include years of great gains and great losses, he said.

"It's like putting one foot in liquid nitrogen and the other in molten lava. On average, you are 72 degrees," Glassman said.

To figure your risk comfort level, you can take a risk assessment test, such as the one accompanying this article. But one of the best ways to gauge risk tolerance is to imagine your own portfolio in a deep decline, experts said.

"We can discuss risk in terms of standard deviations and how much volatility there is. The better way for people to think about it is if you saw your portfolio decline 20 percent in a quarter, what would you do?" said Steve Norwitz, vice president of T. Rowe Price Associates in Baltimore.

Financial advisers look for other signs in assessing risk tolerance. For instance, how much time does the investor spend watching market moves?

"If someone looks at their portfolio every day, I start to wonder if they really are jittery or are they worried about it," Burke said.

Joe Dubinski, a certified financial planner with American Express in Annapolis, gets clues into clients' risk comfort level by looking at their current holdings and their investment history.

"Are they new to the market? Have they been in the market only since 1995 when all the volatility has been upwards?" he said. "Do they have experience in a true bear market?"

Those who invest solely through mutual funds in their 401(k) savings plan at work and only review their portfolio performance quarterly likely won't have the same understanding of risk as an investor used to buying and selling individual stocks for many years, he said.

Often financial experts give clients a reality check by showing them what a knock-down, drag-out bear market really looks like. For example, if you had put $100,000 in the Dow stocks at the beginning of 1973, it would have been worth about $66,000 at the end of 1974, said Paul Shea, a financial adviser with Morgan Stanley Dean Witter in Crofton.

There are other factors to consider when determining how much risk to take, experts said.

Time and goals, for instance. No matter how much risk you can handle, the stock market is not the place for money needed within five years, they said.

Shea said a couple recently visited Morgan Stanley's offices wanting to buy stocks with money they will need to pay a homebuilder in six months. They were advised instead to put the cash in a money market account. Shea said they left disappointed and he's not sure they'll come back.

Some investors know they can't handle wide market swings, but may not realize their portfolios are at risk for that, experts said.

For instance, they may have most of their portfolio in a single stock, tying their fortune too closely to one company's performance, experts said. Or, even with owning a variety of mutual funds, investors can end up not being diversified if the funds hold many of the same stocks or concentrate on the same sector, experts said.

The rising market in recent years also could easily have thrown asset allocations -- how money is divided among stocks, bonds and cash -- out of sync. An investor may have started with a portfolio half in stock and half in bonds and now have 70 percent in equities.

In the past two years, diversification didn't pay off because the growth in the market was largely in technology stocks, Norwitz said. But last year, small-cap and international stocks rallied. "You started to see indications that diversification still matters," Norwitz said. "We're seeing it again now" with the revival of old economy stocks.

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