Section II - Lesson 5F
Investing Basics - Understanding Risk: Risk Management
Now that you’ve taken the time to become knowledgeable about the concept of risk and how it applies to a long-term investment program, you'll begin to realize that risk is not to be avoided, but managed.
When you set long-term horizons, you are managing risk. When you diversify your investments by purchasing an S&P 500 Index fund, you are managing risk. And when you avoid lump-sum timing decisions by dollar cost averaging, you are managing risk.
I seem to be bashing old-time financial planning concepts in these lessons, so let me continue the job. Let me talk about the term "Risk Tolerance" that so many financial planners are fond of using.
When you hear a financial person ask you about your risk tolerance, reach for your wallet and/or checkbook and hold on real tight. Because what this person is trying to do is sell you something - anything - whether it's good for you or not.
The people who use the term are wanting to determine your “risk tolerance” to help them decide what sorts of investments to pitch to you. Rather than educate you about risk so that you’ll feel comfortable about investing in things that will do you the most good, they’ll go along with your apprehensions and recommend things like bonds or cash reserves because of your “low tolerances.”
This is not risk management. It’s risk avoidance, and it would cost you hundreds of thousands of dollars if you go along with it.
By the time you finish this lesson, and later lessons that also deal with risk and emotions, I hope you’ll see the term “risk tolerance” for what it really is. It’s a question asked by people who want to sell you something, and don’t much care whether or not it’s good for you.
Only if your tolerance is high will they recommend a stock fund. If it’s medium, they’ll recommend a bond fund. And if it’s low, God have mercy, you might wind up with an annuity. Beware of such investment people when their lips start moving!
Another financial planning manual concept, which makes no sense to me, is “Asset Allocation.” The proponents of this concept would say, for example, that a young person should be 80% invested in stocks and 20% in bonds while an older person should be only 50% invested in stocks and 50% in bonds.
It goes without saying, of course, that your financial advisor will be happy to collect his commissions or fees as you frequently make changes to your holdings to keep yourself “correctly allocated.”
Forget the fact that you’re contributing to your advisor’s wealth. Forget also that every change you make has tax consequences, and every change requires lump-sum timing decisions, any one of which could prove disastrous. Forget the fact that it makes no sense for someone to cut back owning common stock just because he’s aging.
Why would you ever want to be anything but 100% invested in an S&P 500 Index fund for all of your investment life? It’s simple, safe, convenient, and provides you with a great deal better rate of return than any allocation scheme. "Allocation" simply reduces your return. Think in terms of managing risks, rather than avoiding them.
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