In our personal financial affairs,there is no one-size-fits-all definitionof risk. Every financial strategyhas unique implications for theperson considering it, and theseconsequences shift as a person's age andcircumstances change. Yet, Wall Streetabounds with common misperceptionsabout risk, including the following:
•Stocks are riskier than bonds.One of the few hard and fast rules of theinvestment world is that you cannotgenerate excess return without attendantrisk. For example, stocks tend togo up over the long term, based on thefairly steady growth of the US economy.However, despite this long-term trend,there is much variability over shortertime frames. If you are in your 30s, thegrowth attributes of stocks are criticalto your long-term financial wherewithal,since the primary risk over your longtime horizon is the risk that your purchasingpower and asset base will loseground relative to inflation. On theother hand, if you are in your 70s, thereis a far shorter time frame in which yourassets must make up lost ground if theirreal value should drop significantly—which means that you may want toallocate a higher percentage of yourportfolio to assets with steady principalpreservation characteristics.
A second nuance complicating the"stocks vs fixed income"argument isthat your asset allocation dependsupon the relative valuation and fundamentaloutlook for each asset class thatyou are considering. If the current valuationassumes a future that is toogood to be true, future incrementalreturns may be limited, no matter howsteady the reputation of the particularasset class. On the other hand, if thecurrent valuation assumes a future thatis too bad to be realistic, there may beopportunity relative to the capital youwould have to invest in order to participate.The key variable is the cushionbetween the asset's intrinsic value andits current market price.
•Last quarter's/year's best performingstock/fund/asset class is asure bet. Fads come and go on WallStreet. The prevalence of best andworst rankings makes what is "hot"readily apparent and often prompts anirresistible urge to want to jump on thebandwagon. But, as Yale University'snoted CIO David Swensen points outin his latest book, (Free Press; 2005), "Any excessreturns that may have existed willbe threatened by the influx of newcapital and new participants. Be waryof the market's ability to eliminatesources of superior returns."
•You can never be too rich or toodiversified. After the traumatic stockmarket performance of 2000 to 2002,many investors opted to spread theirassets across multiple managers orfunds. As many have come to realize,however, too much of a "good thing"can lead to headaches. Lack of coordination,index-like performance (orworse, subpar relative performance),lack of control over tax consequences,increased costs in a low-return environment,and too much paper are just a fewof the pitfalls of too much diversity.
•Market timing works. The assumptionthat one can jump completelyin or out of an entire asset class is thestuff of Wall Street legend. Yet, majorshifts like this are very difficult tomake, since they necessitate being righton two decisions—both in and out.These choices typically need to be madeprecisely when public sentiment runscounter to what is comfortable, makingthem exceedingly tough to execute.Scores of studies prove that very fewinvestors are able to make sufficientprofit from whole-scale market timingto surmount the high tax and transactioncosts of this strategy. The bestadvice is to admit that there is no wayto accurately predict short-term marketmoves, choose a variety of solid assetclasses in which to participate, set tacticalranges, and then move asset classweightings to one end or the other ofthese ranges to reflect both your currentmarket assumptions and relativeasset class performance.
is a principal of Lowry Hill, a
private wealth management firm that serves
the investment and financial needs of more
than 300 client families in 38 states. She
welcomes questions or comments at
Carol M. Clark