An up market is good time to assess risk tolerance

Personal Finance

December 03, 2006|By Eileen Ambrose | Eileen Ambrose,Sun Columnist

Investors are braver when the stock market goes up. It's human nature.

Long periods of rising share prices can easily disguise our true stomach for risk.

The best recent example is the late 1990s, when investors aggressively played the market only to find out they weren't the risk takers that they thought they were, once stocks went into a prolonged plunge.

Since summer, investors have swung from pessimism to optimism. Their outlook improved over a series of favorable signs in recent months, said Sam Stovall, chief investment strategist at Standard & Poor's.

The Federal Reserve stopped raising interest rates. Oil prices retreated from their peaks. S&P 500 companies posted a surprising and unprecedented 18th consecutive quarter of double-digit percentage gains in earnings. The Dow Jones industrial average set new records. And Google recently traded above $500 a share.

With investor optimism up, this might be a good time to evaluate your risk tolerance before getting too swept up.

Risk tolerance is one of the key pieces of information you need to determine the best mix of stocks, bonds and cash for you - your asset allocation. Yet risk seems to get short shrift.

John E. Grable, an associate professor at Kansas State University and a risk expert, said financial advisers sometimes criticize him for focusing on risk tolerance. "Some financial planners have actually come up to me at conferences and said, `Risk tolerance doesn't matter ... because a client needs to accumulate $2 million at age 65. If they don't take risk, they won't accumulate it,'" Grable said.

Granted, the more risk you take, the greater the potential for gain. But what good is taking lots of risk if investors are going to bail out when the market hits a rocky stretch? Grable asked. And they're likely to sell at the bottom, when losses are greatest, he added.

Better to know

Better that investors know how much risk they're comfortable with early on, so they can save more, spend less or adjust their retirement date or other goal to fit a more conservative portfolio, he said.

So how do you determine your risk tolerance?

Many investment companies offer online risk assessments, sometimes including portfolio suggestions to fit a person's risk profile. Or, you can get your risk score by taking a quiz Grable developed, available online at

If you haven't experienced the feeling of losing money in a down market, figuring your risk tolerance may take some honest soul-searching.

You can't assume that you will be a risk taker with money just because you bungee jump or take other risks in life, Grable said.

Investors also tend to overestimate their risk tolerance when working with an adviser, said Grable, a former money manager. The reason may be that people want to be viewed by others as a risk taker, he said.

Risk and success

"People who are successful are risk takers in our society," Grable said. "Think of Bill Gates, all the sports super stars and rock stars. They are all risk takers."

For Grable, the more important question on his quiz is: To what extent would your best friend describe you as a risk taker? A real gambler? Cautious? A real risk avoider? Or, willing to take risks after completing adequate research?

"It forces you to put yourself in someone else's shoes," he said. "It makes you be more objective."

Financial advisers say they try to uncover a client's true risk threshold through a series of questions. Advisers typically ask clients to imagine how would they react if they lost money. Would they stay on course or flee the market?

"The key to investing is making sure you stay with your asset allocation," said Fran Kinniry, a principal at the Vanguard Group.

A test

Vanguard tests investors' resolve by using dollar figures to show how different asset allocations fared in the last bear market.

For instance, how would you feel if your $100,000 investment lost $33,000 in 2 1/2 years? That's what happened to investors with an 80 percent stock and 20 percent bond portfolio from March 31, 2000 to Sept. 30, 2002, Kinniry said.

After losing that much, would you continue to invest 80 percent of your remaining $67,000 in stocks?

If not, what about a 60-40 stock-bond split? Investors with that portfolio lost nearly $20,000 in the same time frame, he said.

Or, would you be most comfortable with a 40 percent stock and 60 percent bond portfolio, which lost $5,000 over that time?

Baltimore-based T. Rowe Price Associates asks similar questions of clients.

"If they feel they have a low threshold for pain where a steep decline causes them to sell or lose sleep, they should be more conservatively invested. Even though they might not do as well in the long run," said Steve Norwitz, a Price vice president. "They have to be honest with themselves."

To suggest a topic, contact Eileen Ambrose at 410-332-6984 or by e-mail at Podcasts featuring Ambrose can be found at

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