Managing Investment Risk

Wealthtrack had a discussion about investment risk on the 5/30/08 show (transcript available free for two weeks). The three panel guests, Charles Ellis, Robert Litterman, and Jean-Marie Eveillard, shared some interesting perspectives on risk, which are summarized below:

The panelists discussed three types of investment risk:

Market risk - This is the fluctuation of the total stock market. According to Robert Litterman, investors should determine the maximum loss one is willing to accept. Is it 10, 20 or 50%. Once this number is identified, one can determine an appropriate allocation to stocks and minimizes market risk.

From 1950 to 2007, the yearly stock market return has ranged from a -29.6% in 1974 to 42.3% in 1954. Thus, to cap annual stock market losses at 15%, one should not be more than 50% invested in stocks.

On the other hand, Charles Ellis believes that market risk should be irrelevant to investors that have a 30, 40 or 50 year time horizon. Historically, during that time frame, there is no risk that the market will be down.

Business risk - This is related to whether a particular company will do well or not. For individual stock pickers, this is the most important risk to manage. Understanding a business, its strengths and weaknesses, and the probability of doing well is the most important part of choosing a specific stock. A good analysis of a business will be rewarded with excellent returns when investing in the stock.

Valuation risk - This is related to overpaying for a stock when buying it. However, according to Jean-Marie Eveillard , if one has analyzed the business well, valuation risk will be minimized, since the value will rise in the long term.

Actively managed investing is a zero sum game. The sum total return of all investors is the market return. A small percentage managers will outperform the market, but this will be offset by a larger percentage managers under perform the market. For most investors, buying a global diversified index is the best investing approach.

After watching this show and summarizing the key points, I am considering modifying my investment strategies. Historically, we have been invested in individual stocks and fixed income, such as bonds and CDs. Currently, with the exception of our daughter's 529 plan, we have very little invested in index funds or index ETFs. Many others, such as Vanguard, have long made a case of low cost index funds and the show's discussion on risk have provided me additional insight on how index funds (and good asset allocation) can help minimize risk. Also, I think index funds/ETFs may help simplify managing our investments. While I will always allocate a portion of our funds to individual stocks, I expect to have a larger part of our portfolio in index funds/ETFs in the future.

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This is not financial or investment advice. Please consult a professional advisor.

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