The Flight from Risk

The financial crisis caused investors to run en masse from anything risky, and many still won't buy stocks. The lesson learned: Don't ignore risk

Spencer Platt/Getty Images

By Ben Steverman

A year after Lehman Brothers filed for bankruptcy, throwing world financial markets into turmoil, BusinessWeek examines the landscape for investors and Wall Street. This is the first in a series of stories.

It's been quite a year for investors, a tumultuous 12 months since the collapse of investment bank Lehman Brothers on Sept. 15, 2008.

Firms like Lehman Brothers lived dangerously and paid the price. So did many individual investors saving for retirement. In turn, investors have turned away from anything remotely risky.

While some experts believe aversion to risk is a temporary response to the financial crisis, others insist it should be a permanent change. The events of the past year demonstrate, they say, that the entire investment industry has been embracing too much risk as it prepares clients for retirement. "We've been underestimating risk," says Stephen Horan, head of professional education content and private wealth at the CFA Institute. The last year, and the last decade, have shown that "bad years" are far more frequent than many believed.

A Wild Ride

"Our industry has been driving client portfolios at 60 to 80 miles per hour," says Paula Hogan, of Hogan Financial Management in Milwaukee. "But if they took us out to dinner they would drive at 30 to 40 miles per hour."

Those client portfolios crashed along with the market from 2007 to early 2009, with investor panic reaching its height after the Lehman collapse a year ago. The Standard & Poor's 500-stock index, the broad U.S. stock index, dropped 9% in September 2008 and another 17% in October 2008 as investors worried the world's financial system would stop operating. Casualties of the crisis included not just Lehman but mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE), insurer American International Group (AIG), and banks Merrill Lynch, Washington Mutual, and Wachovia—all forced to either accept government takeovers or be acquired by competitors at extremely low prices.

After those events, "people understand that worst-case scenarios can be far worse than they ever imagined," says Michael Yoshikami, president and chief investment strategist at YCMNET Advisors. By March 2009, the S&P 500 had lost 57% from the October 2007 peak. A subsequent rebound—a 50% advance from March to September 2009—has eased some nerves. But the S&P 500 would still need to gain another 50% to return to its all-time high.

During the most recent crisis, or any market turbulence, investors' natural psychological reaction often makes their situation worse, says professor Vickie Bajtelsmit, chair of the finance and real estate department at Colorado State University. Panicking over their losses, individual investors often sell at the bottom of the market, and then don't buy in again until investments are well on their way to recovery. They essentially lock in losses and miss out on gains, she says.

It's no wonder that many individual investors are still skittish, after the past year's steep losses not just in equities but in corporate bonds, real estate—almost every asset class except cash and government bonds. The appropriate level of equity exposure has become a particular flash point, intensifying a debate about risk among investment experts and pitting financial advisers against clients and even spouse against spouse.

Cashing Out of Equities

Now that stocks have recovered some losses, advisers say many clients are seizing the opportunity to cash out of equities and invest more cautiously in the future. Clients come to financial planners like Frank Boucher, based in Reston, Va., saying they want no exposure to the stock market at all. Boucher warns them that, without the chance for equity gains, they might need to work longer, save more, or spend less. "They say, 'That's fine. At least I get to sleep at night,' " Boucher says.

These risk-averse investors are often on the right track, some advisers and academics say. The investment industry has been too cavalier about the dangers of investing, too willing to emphasize the benefits of risk and ignore the potential pitfalls. "Financial planners are experiencing a tremendous backlash from their clients," says Zvi Bodie, a professor of management at Boston University and a leading advocate of a more conservative investing industry. "People are being put at risk without being told how much they're at risk," he says.

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