How much investment risk can you handle? Here's a yardstick
Now that people have had a few months to think about what happened to the stock market - and maybe their own stocks - in October, they've begun to think a bit harder about how much risk they want to take with their money. There are two ways to measure risk when investing: a subjective measurement, or whether the investor can sleep at night; and an objective measurement, known as beta, which compares the risk of stocks and mutual funds against the risk of the overall market.Skip to next paragraph
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On the subjective side, ``we lost clients who had done very well for a long period of time but who lost a little in the meltdown,'' says Michael Stolper, a San Diego investment management consultant who finds portfolio managers for affluent individual investors and corporate pension plans.
``We lost clients who said, `This is not for me.' And these are people who have been around for 15 or 20 years, they've been investors their whole lives.''
These people, Mr. Stolper says, failed to adequately measure their own tolerance for risk before investing. And since tolerance levels for many people have moved down considerably since Oct. 19, he feels it may be time to take some new measurements.
For him, these measurements are largely subjective, and are a look at the investor's own temperament. The fastest way to do this, he believes, is to see how much time a client spends worrying about an investment, or much much sleep he loses over it.
``We've told our clients that if they're having trouble sleeping, that's a very clear message that their portfolio structure is inappropriate for who they are temperamentally,'' Stolper says. ``I think the perception of risk and volatility is different than it was before October, and the reaction is going to be to reduce equity exposure, period. And that's going to last a while.
``People need to remember that traditionally equities have not been a core asset, they've been a residual asset. You pay off the mortgage on your house, you fund your IRA, you get sufficient savings, then equities start getting important.''
``I don't think there's ever a time to stay totally away from the stock market,'' Stolper adds. ``There are times you scale down and times you scale up.''
People who are thinking of scaling up may want to consider a more objective measurement of risk, known as beta. This concept has long been applied to common stocks, but in recent years it has been used more often with mutual funds. Combined with another measurement - alpha - beta can help investors figure out how risky their funds are, and whether greater risk means greater return.
The beta measures how much the price of an individual stock or a fund fluctuates in comparison with the market as a whole. Most comparisons are made with the Standard & Poor's 500 stock index, and a stock or fund that exactly mirrors the volatility of that index has a beta of 1.0. A fund with a beta of 1.4 would do 40 percent better than the S&P when the market increases and 40 percent worse when the market is going down.
A fund with a beta of 0.90 would be good for someone who wants to be in stocks but doesn't want to get burned too much when the market drops.
``If you expect the market to go up, if you think you have a crystal ball, you buy this kind of fund, because you think it's going to outperform the averages,'' says Lewis J. Altfest, a financial planner and professor of finance at Pace University in New York.
``You'll find that the high betas are the aggressive growth funds. They are often the specialty funds, and the low betas are more likely to be the growth and income funds. The low-beta situations are for more stability.''
Some investors balance a high-beta fund with one that has a low beta, so while the overall performance may not be as flashy, the risks aren't as great, either.
In addition to betas, investors should also examine a fund's alpha. This measures how a fund has actually performed, after adjustment for risk. A fund with an alpha of 0.04 would have done 4 percent better than the market annually after adjusting for risk.
``Over the last several years,'' Mr. Altfest says, ``the lower-beta funds have outperformed the higher-beta ones.''
Information on betas and alphas for no-load funds is included in the ``Handbook for No-load Fund Investors'' (PO Box 283, Hastings-on-Hudson, NY 10706; $38). For all funds, Morningstar Inc. publishes betas and alphas in its ``Mutual Fund Sourcebook'' (53 West Jackson Blvd., Chicago, IL 06004; $175 for four quarterly issues). While this is more expensive, some brokers who sell load funds and some libraries may have it.
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