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What's Your Tolerance for Risk?
Investment strategies that keep you up at night may not be worth a promising return

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If canasta is your idea of a wild time, your risk tolerance may be lower than, say, someone who juggles chainsaws. But no matter how many chances you take in your everyday life, you have to be aware of your tolerance for financial risk if you want to become a successful investor.

Sticking with a long-term investment plan is the key to being a long-term winner. It's best not to own investments that scare you witless, because you'll probably sell at the first sign of trouble--and at a loss.

Analysts have identified numerous categories of financial risk. Market risk is the chance that the entire stock market will go down, dragging your stocks or funds with it. There's event risk, which is the possibility that something dreadful will happen to the company whose stock you own. Opportunity risk means that you could have done something smarter with your money.

In general, financial risk refers to the possibility of losing money because an investment declines in value or gets bested by inflation. The more risk you take, the greater your possible payoff--within reason. For example, stocks usually return more than ultrasafe Treasury bills or bonds over periods of 15 years or more.

You can find exceptions on both ends of the risk spectrum. Very high-risk plays--lottery tickets or cheese futures--rarely pay off enough to compensate for losses. Very low-risk strategies, such as passbook savings accounts, nearly always lose out to inflation.

How can you figure out your appetite for risk? NASCAR drivers aren't necessarily more aggressive investors than backgammon champs, says Richard Thaler, professor at the University of Chicago. Investors often have different risk levels for different investment objectives. "I might have one risk tolerance for my children's education fund and another for my pin money," Thaler says.

You might also take more risks with your earnings than with your principal. Suppose you went to a casino with $500 and won $200. Most people would not mind taking risks with their $200 winnings because they don't consider it, in gambling parlance, house money. "Many investors in 2000 felt they were gambling with house money," Thaler says. They don't feel that way anymore.

Researchers disagree about the best way to measure risk. One common method is standard deviation, which examines how much an investment's price swings. The higher the standard deviation, the more volatile the investment. For example, the Bond Fund of America, which invests mainly in corporate bonds, has a standard deviation of 3.83, according to Morningstar Inc., the mutual-fund tracker. Meanwhile, Fidelity Select Electronics, a technology fund, has a standard deviation of 64.84. You don't have to be a statistician to grasp that the tech fund is much more volatile than the bond fund.

Financial economist William Sharpe, a Nobel laureate, suggests looking at risk in an entirely different way. Forget the day-to-day market fluctuations. For most investors, the greatest risk is not having enough money to meet their goals. Employees with 401(k) plans, for example, want to know the odds that they will have enough money to retire. One answer lies with Monte Carlo analysis, named for the famous casino. This method looks at the historical behavior of various investments over long periods of time and tries to determine your odds of reaching a goal. You can run your portfolio through various Monte Carlo scenarios at Sharpe's Web site, for a fee.

Once you determine your risk-taking comfort level, you can form an investment strategy that suits your long-term needs. We asked John Rekenthaler, president of Morningstar Online Advice, to create sample portfolios for conservative, moderate, and aggressive investors (table). Rekenthaler's aggressive portfolio is 100% stock and is geared toward investors who don't need to tap their savings for at least 10 years. The moderate fund adds a 30% position in bonds, which often rise when stocks fall and provide a cushion against losses. The conservative portfolio puts just 40% in stocks, with the rest in bonds.

After determining the asset allocations, Rekenthaler divvied up each portfolio into investment subcategories. In the aggressive portfolio, he put 30% into two growth funds--White Oak Growth, a large-company fund, and Bogle Small-Cap Growth. Growth funds are volatile but can pay off in the long term. The conservative portfolio is weighted toward value funds, which look for stocks of companies whose prices are low relative to earnings or book value. Many are beaten-up, unloved stocks that can be less volatile than growth stocks.

Rekenthaler salts all three portfolios with international funds for extra diversification. About half of all stocks are traded abroad. International holdings, when mixed with U.S funds, can sometimes reduce a portfolio's volatility. Master's Select International, in the aggressive portfolio, has a larger growth component than Tweedy Browne Global Value (which can also invest in U.S. stocks) in the moderate and conservative mixes.

Bond funds, too, vary according to risk. The least risky, such as the conservative portfolio's Dodge & Cox Income Fund, invest in short-term bonds issued by the U.S. government or companies with top credit ratings. More aggressive funds, such as T. Rowe Price High Yield in the moderate mix, choose among issues with low credit ratings, which adds yield--and risk that companies can't pay their debts.

When you're picking mutual funds, don't be intimidated by the thousands available. If you look for funds open to small investors that have a five-year track record and no sales charge, you're down to about 390. Choose funds in the top 25% of their investment category over the past five years, and the field narrows to 100.

Aggressive investors should favor small, nimble funds. For example, Wasatch Ultra Growth has $226 million in assets--a peanut compared with the most popular mutual funds. Cautious investors will want larger, more conservative funds. The Vanguard 500 Index in Rekenthaler's conservative portfolio tracks the largest U.S. stocks and has no small-stock component. The $3.1 billion T. Rowe Price Small-Cap holds more stocks than $244 million Westport Small Cap, which reduces its volatility. Why are both Harbor Bond and Dodge & Cox Income in the conservative portfolio? Harbor is a bit more aggressive--for a bond fund, that is.

No matter what your risk tolerance, the basic relationship between risk and reward still stands. If you want safety, you'll pay through lower returns. If you want high returns, you must be willing to get clobbered from time to time. When investors understand risk, they realize that their desired rate of return requires taking at least some chances.

APRIL 2, 2002

By John Waggoner, USA Today

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