The Retirement Corporation of America

Understand What Risk Is Really All About

SINCE HARD TIMES and bear markets are inevitable, why should you take any risks at all with your money? Why not keep your money safe in an insured bank account, so you never worry about losing it in some economic or market setback? Obviously the risk of capital loss is real. If you don't think about the risk of losing your money when you invest, you'll never be a very successful investor. You would be apt to take too many chances, pick too many risky investments, invest too much or invest at the wrong time.

However, the risk of capital loss isn't the only risk you face as an investor. Beyond that, there is:

•  Inflation risk. Even when there isn't a lot of inflation in our economy, there is always some inflation. Money in an insured bank account is free from the risk of capital loss. But bank accounts don't offer any protection against inflation. Every year, your money is being eaten up, a little bit at a time, and sometimes a whole lot at a time. One reason to invest in stocks is that your return can grow, year after year, by more than enough to offset inflation.

•  Lost opportunity risk. In a growth economy, every day you aren't invested in the stock market is a day in which you have let opportunities pass you by. Remember that when the longest bull stock market in history begin in 1982, the Dow Jones industrial average stood at 777. Before it ended in 2000, it had moved above 11,000—an increase of more than 1,300% among the biggest, blue-chip companies in the land.

•  Tax risk. You can't make investment decisions without thinking of the tax consequences. Selling a stock may help preserve a capital gain—but it also exposes you to paying capital gains taxes. Municipal bonds usually pay a lower rate of interest than bonds issued by the U.S. Treasury—but every penny of interest from those bonds is exempt from federal income taxes. The income from money invested in Treasury bonds, notes and bills is exempt from state and local taxes. Never make investment decisions based solely on tax considerations, but never make an investment decision without understanding the tax consequences.

•  Outliving-your-money risk. That's the ultimate risk—the one risk you never want to take. By the time you know you have succumbed to it, it is too late. Your money is gone, and you are still alive and kicking. You can ask your kids for help, or quickly learn a new skill and go back to work.

Don't Avoid Risk—Learn to Live With It

So you can't avoid risk in investing your money—not if you want to manage your wealth the way professionals do. You can minimize that risk, however. You can take steps to control it.

You can't ensure that you will never lose money. Every investment professional who has ever lived has lost money on investments. Some have lost a great deal. It isn't required, though, that you never lose money. All you have to do, to give yourself the financial future you want, is to win more often than you lose. That is eminently doable—even in the face of recessions and bear markets—if you just follow some safe, sane rules of risk management. Here they are:

•  #1: Practice asset allocation. Again, that's the risk management rule that is covered by the saying: "Don't put all your eggs in one basket". Remember that:

- Stocks offer the highest return, but pose the greatest risk of loss.

- Bonds pose a lower risk of loss, but offer a lower return.

- Cash (money in the bank or in a money market mutual fund) poses virtually no risk of loss, but poses the lowest return.

Since each class of investment offers its own unique blend of risks and rewards, it would be hard to choose which one to invest in. Therefore, you don't choose just one asset class to invest in. You divide your money among the three asset classes.

There's no one-size-fits-all asset allocation. A useful rule of thumb is to invest your age in bonds and cash and keep the rest in stocks. At 30, you'd be 30% in bonds and cash and 70% in stocks. At 50, you'd be 50% in bonds and cash and 50% in stocks.Investing only in stocks works fine when the markets are rallying—but it can kill you when the world turns turbulent. Investing only in bonds and cash makes sense when the world turns turbulent—but can expose you to inflation risk, lost opportunity risk and outliving-your-money risk when the markets are rallying.

Just to make the point again: Don't put all your eggs in one basket and you should be able to ride out even the most turbulent times.

•  #2: Diversify. You can allocate your assets until the cows come home, and still leave yourself wide open to risk. You could do that by not diversifying your investments within each asset class.

You could get by with a single money market mutual fund to hold the cash portion of your investments. Most money market funds invest in roughly the same types of securities—short-term government and corporate issues. And most money market funds offer roughly the same return at any given time.

You might want to consider several different types of bonds for the bond portion of your allocation—maybe some six-month Treasury bills, maybe some three-year Treasury notes, and maybe a 30-year Treasury bond. You may also want to make life simple, and just invest in a Treasury bond mutual fund, and perhaps in a high-yield "junk bond" mutual fund—one that invests in lower-grade bonds ("BB" grade and lower), but pays a higher return for taking the risk.

When it comes to the stock portion of your allocation, you definitely want to diversify. One argument in favor of mutual funds is that they provide that diversification, built in, when you buy the fund. That's why many investors will never go beyond mutual funds. Consider buying several funds—a large-cap fund, a smaller-cap fund, a balanced fund (which invests in stocks and bonds) and maybe a foreign stock fund.

•  #3: Give yourself time. Based on studies going back some 50 years, there is a 20% chance that a stock market portfolio will lose money in a given year, but virtually no chance at all that a portfolio of stocks will lose money if held for more than 10 years.

The lesson to be learned from that is pretty plain: The more time that your money can stay invested, the more risks you can take with that money—and the less likely you will be to act precipitously when the world turns turbulent. Here's some guidance:

- If you will need the money within a year, then safety is all-important, and risks should be avoid completely. Keep your money in a money market mutual fund, a bank CD or a Treasury bill.

- If you will need the money in three years or less, then safety is an important consideration. Keep your exposure to stocks to one-third or less of your total portfolio, with the rest in cash, or in shorter-term bonds.

- If you will need the money in three to seven years,
then safety is your secondary consideration. Top consideration goes to earning the highest return. You can keep most of your investments in stocks, with 25% or less in bonds or in cash.

- If you won't need the money for at least seven years, then you can invest totally in stocks.