How to Measure and Manage Investment
Risk
How to Measure and Manage Investment
RiskRisk - the possibility of losing money - is one of the most feared words in investing. Despite most people's aversion to risk, the history of market manias shows that most people - even some of the most risk-averse - have the ability to abandon their fear of losses when asset prices soar for a long time and everybody else seems to have made a lot of money.
So what gives some people the ability to control their emotions and make cool and calm decisions? Two main reasons are that they know how to measure risk and how to manage it. And, to the extent that individual investors learn both, they increase their chances for making smart decisions that keep their portfolios on track toward meeting their goals.
Beta - Professionals have two common ways to measure risk. The first is beta, which is how closely a portfolio's performance matches or varies from that of a benchmark index. The benchmark for large-company U.S.-traded stocks is the S&P 500 stock index, while a general benchmark for bonds of medium-range maturity is the Barclays Aggregate Bond index. The performance of indexes is normally expressed as a percentage and reflects their total return, which is a combination of any interest or dividend payments and their change in price.
Beta is expressed as a number on an open-ended scale, and it can be a positive number, a negative number, or zero. A beta of 1.0 means that a stock or portfolio's returns are identical in both size and direction to the benchmark, while a beta of -2.0 means that the portfolio's returns are twice as large in the opposite direction of the index. For example, when the S&P 500 index return is 12%, a portfolio with a beta of 1.0 should also return 12%, while a stock with a beta of -2.0 should lose 24%. A beta of 0.0 means there is no patterned relationship between the two returns.
Standard deviation - A second way professionals measure investment risk is with standard deviation. Expressed as a percentage, it reflects a range of returns above and below an annual average rate of return for the stock or portfolio itself, without reference to a benchmark. It's standard deviation that measures the way many define risk: volatility.
In statistics, when applied to investment returns, one standard deviation covers about two-thirds of all returns. So a portfolio that has an average rate of return of 9% and a standard deviation of 12% means that in six to seven years out of 10, the portfolio's returns range between -3% and 21%. In general, a lower standard deviation is better, because it reflects less chance of a negative return.
Individual investors can use several methods to help reduce the risk and volatility in their portfolios. These include:
Managing risk isn't about avoiding all losses, since they are an inevitable and normal part of the investment process. Instead, it's about minimizing your losses while achieving the rate of return you need to reach your financial goals.
Start Longevity Planning TodayJust because we are living longer doesn't mean we're going to remain healthy throughout our longer lives. In the past, seniors who lived long lives tended to be healthier in their senior years, which meant they had lower medical bills. But while some credit goes to more active, health-conscious, smoke-free lifestyles, it's safe to say that today's seniors owe more to prescription drugs and medical advances for lengthening their lifespan.
And as we all know, health care costs money - lots of it. In fact, Fidelity Investments found in its 2011 Retiree Health Care Costs Estimate study that a 65-year-old couple retiring this year with Medicare coverage will still need $230,000 to pay for medical expenses throughout retirement, excluding nursing-home care.
Speaking of which, with a longer life comes the greater likelihood of needing assisted living or long-term care. According to the Genworth 2011 Cost of Care Survey, assisted living averages $39,000 a year, and nursing homes average more than $70,000 a year - per person. For a couple, this kind of care could cost far more than their annual household income during their highest earning years.
Some of the things you can do to plan for a long life come down to repositioning your assets - as well as your approach toward life.
For example, lifestyle factors can contribute significantly to both how long you live and the quality of life you lead. Areas where most of us could easily pay more attention include lower caloric intake, higher vegetable and fruit consumption, a higher fiber diet, lower body fat, and regular exercise.
Furthermore, research has revealed that as you age, learning new skills can help protect the brain against age-related memory decline and dementia. This is particularly important during retirement when you no longer have the day-to-day cognitive challenges that kept your mind active. Effective brain-stimulating activities include doing crossword puzzles, playing video games, learning a new skill such as cooking or ballroom dancing, or learning a foreign language.
Studies have also found that people who feel the most socially connected are four times less likely to develop serious illnesses. A Brigham Young University study reports that social connections - friends, family, neighbors, or colleagues - improve our odds of survival by 50%. In fact, the study asserts that low social interaction is the equivalent to smoking 15 cigarettes a day or being an alcoholic (Source: Social Relationships and Mortality Risk, July 2010).
This is a good time to think about your priorities and align your assets to support your personal goals (not just your financial aspirations). In fact, you may need to reposition your assets to accommodate a longer life with fewer assets than you previously thought.
When we talk about reevaluating and establishing financial goals, it shouldn't just be about seeking a 10% average annual return on your investments over the next five years. You should consider what you actually want to do with your money. What is the purpose of it - to live out your life comfortably and secure, or to live in luxury, entertain, and travel extensively? The latter lifestyle may no longer be your priority, so before you determine what changes to make in your finances, it's important to establish what you want from your life.
Even in retirement, your portfolio may need to be positioned for both growth and security. Growth to meet the challenges of a long life and the impact of long-term inflation and health care, but also sources of secure income to ensure that your daily essential living expenses will be met.
During this continuing era of slow economic recovery, remember that one of the key components to managing wealth is managing risk. In addition to the traditional sources of retirement and estate planning, consider today's popular insurance options, such as annuities, long-term care, and life insurance policies.
Life is long, and it's getting longer with each generation. They say that life gets in the way of even the best-laid plans, and it's true. Every plan - even a financial plan - requires tweaking and adjusting periodically to account for current events. However, your personal goals may well remain the same for the rest of your life. So if you establish the purpose of your money - what it is that you want out of life - then you can reposition your assets to help you reach those goals.
Major Estate Tax Law Changes AheadOn December 31, 2012, the provisions of the law that took much of the sting out of estate taxation are due to expire. It was the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, or TRA 2010, signed into law on December 17, 2010, that ushered in the lightest levies against inherited assets in more than 75 years. Among other things, it raised the estate tax threshold to $5 million per person ($5.12 million in 2012), and lowered the estate tax rate to 35%.
The rate hadn't been that low since 1931, when the top rate was 20%. It rose to 45% in 1932 and soared to 77% from 1941 through 1976, before going down to 55% in 1984, where it remained through 2001. Changes in the 2000s gradually brought that rate down to 35%.
With the expiration of TRA 2010 set for the end of 2012, estate taxation will revert to what it was in 2001: taxes begin on estates of just $1 million (still twice that for married couples), and the tax rate moves back up to 55%. To illustrate the impact: the taxes due on a joint estate of $5 million will rise from nothing this year and next to $2.75 million in 2013.
What's more, when TRA 2010 expires, it will also become more difficult to reduce your estate by gifting. In sync with the lowering of the threshold for estate taxation, the lifetime gift tax exemption will be cut from $5.12 million per person ($10.24 million for couples), to just $1 million ($2 million for couples).
If you're among the Americans who would be affected by the reset of estate tax laws in 2013 (if you have an estate worth more than $1 million and/or would consider gifts of more than $1 million), then there are steps you can take today to take advantage of the current favorable estate tax laws. Those steps include:
While it's possible that Congress could pass new laws before the end of 2012 that make the estate tax code more benign, with federal spending cuts in the neighborhood of $1 trillion on the table along with proposals to increase taxes on the wealthy, it appears that an extension of estate tax relief is a long shot in the near term.
Take Inflation into AccountInflation is one of the most insidious risks investors face for two reasons: 1) it's unavoidable, and 2) it's easily overlooked.
At an annual rate of inflation of 3%, a loaf of bread that cost $3.00 last year costs $3.09 this year. That doesn't seem too bad. In fact, since 1926, the U.S. has experienced an annual rate of inflation of 3%, which is deemed a healthy rate for economic growth.
The other way to look at that 3% hike in prices is that the dollar you owned last year is now worth just 97 cents. Again, that alone doesn't seem like a big deal, until you compound that rate over time. After 10 years, at that same rate of inflation, a dollar is worth 74 cents; after 15 years, it's worth just 64 cents; and after 25 years, it's worth only 48 cents.
Financial experts and economists make a distinction between "nominal" and "real" or inflation-adjusted growth. Nominal growth means that if the market value of your IRA rose from $100,000 to $103,000, it grew by $3,000, or 3%. But if the prices of all goods and services also rose 3%, your "real" return was 0% - inflation discounted every penny of growth you earned.
Think of inflation like an annual tax on your retirement account. On the last day of 2011, you withdraw $3,000 from your account to pay your "tax" bill, reducing the balance from $103,000 to $100,000. By December 31, 2012, your IRA is worth $103,000 again, but your "tax" bill is $3,090 - 3% higher. Now when you make your withdrawal, your account balance slips under $100,000 to $99,910. If your return and inflation remain at 3%, by the end of 2013 your account will be worth $102,908 and your tax bill will be $3,183.
Do this for 20 years and your annual "tax" bill climbs to $5,261 and your account balance has declined by about 25% to $75,401. This example is presented for illustrative purposes only and does not project the performance of a specific investment.
The direct implication for investors is the need to account for inflation in their financial plans. The way financial planners do this is to either 1) state your goals in present dollars (i.e., don't adjust them for the effects of inflation) and subtract an assumed rate of inflation from your expected return; or 2) state your goals in future dollars by compounding your current expenses by the assumed rate of inflation and use your nominal rates of return to project your future asset values.
To deal with inflation, investors and retirees may have to make some adjustments in how they invest or reduce their lifestyle in retirement. Since historically stocks have been the best way to keep your investment assets growing faster than inflation, even the most conservative investors may need to keep a healthy percentage of their portfolios invested in stocks.
The investor who thinks he's avoiding risk by staying out of the stock market is ignoring inflation risk. Without some offset for the eroding effect of inflation, such ultraconservative investors virtually guarantee that the longer they live, the less purchasing power they will have.
Does your financial plan take inflation into account, or are you already retired and withdrawing as much or more than your portfolio earns to support your lifestyle? These are absolutely essential questions to address.
Your Parents' Estate PlansEstate planning can be a difficult subject to discuss with your parents. But to help ensure their estate is settled quickly according to their wishes, family members should have some basic information. You don't need to know the specifics, but you should find out:
Copyright © 2012 Integrated Concepts. Some articles in this newsletter were prepared by Integrated Concepts, a separate, nonaffiliated business entity. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.
FR2011-1118-0002