Rules of the Game: Set Risk Tolerance

 | May 17, 2013 | 3:00 PM EDT  | Comments
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Stock quotes in this article:

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In my previous column, I ranted about pressure -- inflicted externally as well as internally -- to trade news events, opinions, and politics.

By warning people about such fear-based trading (because that's exactly what it is, no matter what kind of sophisticated, analytical language you try to couch it in), I'm really sounding the alarm about taking on inappropriate risk.

Most people don't have an idea whether they have the tolerance or the need for a conservative, moderate, or growth portfolio. Those who believe it's desirable to chase performance in any situation will automatically say they need growth. So will those who have panicked because they failed to save enough in their early working years, and now believe active growth trading is their only solution to building up any retirement assets.

Others who are afraid of losing assets will automatically say they need a conservative portfolio. That's not necessarily a wrong answer, although it should be the result of a comprehensive financial plan, not a worried guess.

It's also important to realize that not all assets are designed to achieve the same objectives. I've had new clients come in with an existing portfolio that they believed was "conservative." The holdings -- it's actually a stretch to even call it a portfolio -- consisted of a few all-stock mutual funds.

In what universe is that conservative? Oh, I know. The universe of people who buy a handful of high-beta small- and mid-caps like Fleetcor Technologies (FLT), Lumber Liquidators (LL), or Alaska Air (ALK), and call it a day. That's just a collection of volatile growth stocks that dial up risk to an excessive degree. For investors seeking some excess returns, an all-equity portion of a portfolio is often appropriate, provided that it's balanced with fixed income elsewhere.

But I'm not here to champion fixed income over equities, or vice versa. It always comes back to what I mentioned earlier:  The appropriate risk levels. Do pork bellies give you the proper level of risk? Junk bonds? Iraqi dinar?

The long-term average volatility for stocks is about 15% to 20%. But there are outlying years, such as 2008, that skew results and destroy wealth.

What is the lesson? There will be those volatile times. It's probably comforting to some who believe that they will be able to sell their stocks at just the right time, keep their gains (or cut losses very short), and evade the steep losses of a 2008 or even summer of 2011 situation.

But that's pretty much impossible for most investors and traders, who trade opinions (as I noted early in the week), or who simply aren't able to time the market as perfectly as the purveyors of trading systems suggest you can.

So think carefully about what your real investing objectives are, and what kind of risk tolerance that means for you. Once you have landed on your long-term risk profile, stick to that, and don't get distracted by high-beta stocks, dividend stocks, gold, or whatever catches your eye.  

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