Monday, January 08, 2007

An Investor's Focus Should Be On Risk

If equity market history has a tendency to repeat itself, an investor will want to pay particular attention to the risk he or she is willing to assume in constructing their investment portfolio.

Zvi Bodie and Paula Hogan wrote an article, For Long-Term Investors, the Focus Should Be on Risk, that begins:
There is a common notion that stocks, at least if held for a long-time, usually outperform other assets, so that stocks should be the cornerstone of any long-term portfolio.

If, when this idea is presented, you protest: “Wait a minute. Stocks are also risky!” the reply is either, “Stocks have done well in the past and so they will probably also do well in the future,” or “If you have a long time horizon, you’ll do well in stocks.”

However, the thoughtful investor must also wonder: “But what if stocks don’t do well? What happens then to my retirement?”

And in this self query, the more appropriate approach becomes clear: It makes more sense to think first about what risk you are able and willing to bear, and then to think about what potential investment returns you might be able to capture...
Risk is not simply losing money in a down market, but is experiencing a return that does not result in an investor's investment assets attaining annual asset level targets at the same time regular withdrawals are being made from the investments. Bodie and Hogan note in their article:
"The fact is, lower than expected returns could happen—even for many years in a row—which is exactly what makes stock ownership a risky investment, not a certainty. Lower-than-expected returns that last for a long time and/or that are severe in nature would have the impact of dramatically lowering the ending value of your portfolio, and thus could significantly threaten your ability to meet financial goals. While the probability of such an event is low, the consequences are potentially devastating and so are worthy of careful consideration. What the current reasoning omits is the fact that as the investor’s time horizon lengthens, the range of possible ending values for the portfolio also increases, and that these widening ranges include the low, but still positive possibility of a whoppingly low actual versus expected portfolio ending value (emphasis added)."
Also contained in the article are examples of different portfolio returns along with withdrawal assumptions. The examples note that negative returns can be detrimental to one achieving retirement goals and objectives.

Historically, a dividend growth portfolio has been less volatile in down markets. If the market is down -20% and ones investment portfolio is down -18%, the investor has beat the market on a relative basis, but likely not achieved retirement goals and objectives. Bodie and Hogan address this issue in their article and conclude:

In sum, rather than reaching for a high stock return because it might come true, the goal of investing is better expressed as having enough cash on the day a bill comes due—for example, for college tuition for your children, and/or enough cash to maintain or improve your standard of living throughout retirement with minimal chance of having to go backward in your daily standard of living. These are the typical actual concerns of individual investors.

Against this standard, beating one’s peers or surpassing the market averages, or achieving a particular targeted rate of return all pale in comparative appeal. As the investment saying goes: “You can’t eat relative returns.”

For Long-Term Investors, the Focus Should Be on Risk
The American Association of Individual Investors
By Zvi Bodie and Paula H. Hogan

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