News Room
 Don’t Avoid Risk – Manage It Instead
By Brenda P. Wenning
November 2008
In an effort to avoid risk, many investors expose themselves to the risk of not saving enough for retirement and other financial goals.
Women in particular are at risk, ironically, because they often go too far in trying to avoid risk. A study released in July by Hewitt Associates, found that women are more risk averse than men, earn less and save a lower percentage of their earnings.
The Hewitt study also notes that women need to save more than men, because they spend fewer years in the workforce and live longer. The study also finds that four out of five people – women and men – aren’t saving enough to continue their lifestyle after retirement and that 90 percent of women are unsure about managing their finances.
Hewitt’s results reinforce the results of many other studies. For example, a 1996 study in Financial Counseling and Planning concluded that 63 percent of single women and 57 percent of married women were unwilling to take any investment risk at all (compared with 43 percent of single men and 41 percent of married men).
Today is especially important to accept risk, as inflation is at its highest level in years, while interest rates remain near historic lows. As a result, the most conservative investments, such as money market funds and certificates of deposit, are earning returns that are lower than the rate of inflation.
When your investments earn less than the rate of inflation, every dollar you save shrinks over time, rather than increasing in value. That’s called a negative real rate of return. If your savings are earning a 3 percent return, for example, and the rate of inflation is 5 percent, by the end of the year, your dollar will have the buying power that 98 cents would have today.
That may not seem like anything to worry about, but consider what will happen over time. If you lose 2 percent on a dollar every year for just 10 years, every dollar you save will be worth just 82 cents at the end of that period. After 20 years, it will be worth just 67 cents.
Conversely, if you earn positive real returns – if your returns exceed the rate of inflation – compounding can have a dramatic impact on the overall value of your investment. If you earn just 2 percent above the rate of inflation, every dollar you save will be worth $1.22 after 10 years and $1.49 after 20 years.
Your returns and the rate of inflation will, of course, vary over time. These examples are hypothetical and are meant for illustration purposes.
The point is, if you want returns that are high enough so that you can retire and continue your current lifestyle, you will likely have to develop a tolerance for risk, as greater returns generally require greater risk.
Risk Management Techniques
So how can you earn positive real returns without taking on an exceptional amount of risk? By managing risk instead of avoiding it. The following investment techniques can help investors earn the returns needed to achieve financial goals without taking on unnecessary risk.
Portfolio allocations. Diversification is key to managing risk. If you invest all of your money into one stock, your investment performance depends on the performance of one company. If that company performs like Enron Corp., for example, you could lose everything.
Diversification helps investors manage risk, because the risk in one investment balances the risk in another investment. At any time, one asset class will outperform another. Diversification spreads the risk and ensures that the investor participates to some degree when an asset class appreciates in value.
Many investors keep set percentages of their assets allocated in various types of investments and regularly rebalance their portfolio to keep the allocation consistent. To maintain the same allocation, you need to sell some assets that increase in price and buy more assets that decrease in price. Following this “buy low, sell high” philosophy may increase your returns long term.
Those seeking superior returns to those using portfolio allocations may invest more dynamically based on market conditions and shift quickly to defensive positions when market trends change. This approach may result in higher long-term returns, but will be less palatable to the risk-averse investor.
Price targets. Investment managers typically invest in a stock with a specific price target in mind. Based on their analysis of the stock, they expect it to reach a target price of a certain amount over a given period.
Price targets are obtained through a careful analysis of the stock, including a review of its trading history, its price-to-earnings ratio and many other factors. There are many methods for calculating the target price, and the price achieved through an analysis of fundamental data, for example, could vary significantly from the price target calculated using a technical analysis, which relies on market trends.
Once the target price is achieved, all or a portion of the stock is sold.
Stops. Of course, some stocks never achieve their price targets and some drop in value. A “stop” or “stop-loss order” protects the investor by automatically selling shares when the stock price drops to a predetermined level. If the investor is uncomfortable taking a loss of more than 15% on a stock selling for $100 a share, for example, the stock would automatically be sold if its price dropped to $85.
Stops are often used by investors when they are unable to monitor their investments over an extended period, but they may also be used in conjunction with price targets to create a trading range that the investor feels comfortable with.
Alerts. Traders on Wall Street have long used sophisticated systems to help them identify the most appropriate times to buy and sell. “Program trading” was criticized as a system that helped the rich get richer, as it was unavailable to the average investor.
Today, though, investment managers with the appropriate trading systems can help their clients by alerting themselves when heavy buying or selling of a stock takes place, or when other critical changes in the market occur. No one can predict with certainty how the market will perform at any given time, but investment professionals should have a good idea about support and resistance areas in the market, and whether the market can sustain them.
Hedging. You’ve likely heard the term “hedging your bets,” which applies to gambling. A gambler may decide to bet on two different outcomes as a way to improve the odds of winning. Likewise, hedging can mitigate risk for investors.
Hedging is used to reduce the risk that an investment will decrease in value by investing in an offsetting position in a related security, such as a futures contract. A futures contract obligates the buyer to purchase the stock or other asset at a predetermined price at a future date.
Hedging can be an effective way to reduce price volatility. For example, many heating oil companies purchase future contracts because of uncertainty about the cost of oil during the upcoming heating season.
These are just some of the investing techniques that can be used to manage risk. Of course, it is also important for investors to accept that that their portfolio will not always perform up to expectations. Some investments will lose money. By managing risk, though, you can reduce volatility and increase the potential of your investments.
There are no shortcuts on the road to financial success, but managing risk can make the journey as smooth as possible.
Brenda P. Wenning is president of Wenning Investments, LLC of Newton, Mass. She can be reached at Brenda@WenningInvestments.com or 617-965-0680. For additional information, visit her blog at www.WenningAdvice.com.
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