Business Matters Understanding risk is key for stock market investors

By Kevin FitzGerald

I’ve been investing for several years and have been getting returns of about 20 percent per year. Recent declines in the market have erased a lot of my profits. I’m wondering what kind of strategy should I be following and what risks are there in the market.

— A.K., Yonkers

Over the last three years the Dow Jones Industrial Average (DJIA) has generated impressive returns despite volatile conditions — 21 percent in 1997, 24 percent in 1996 and 34 percent in 1995. Against the backdrop of this bull market, most investors have adopted a long-term approach and accept market fluctuations as a normal aspect of investing but also have unrealistic expectations for the future performance of their portfolios.

To illustrate, the Index of Investor Optimism, a joint effort of Paine-Webber Incorporated and the Gallup Organization, shows that investors who have the least experience expect a return of more than 18 percent on their portfolios. But perhaps even more alarming, the Index findings also show that investors say the minimum "acceptable" rate of return next year is 11 percent.

Considering that over the last 71 years common stocks returned an average of 10.7 percent, investors should think about stepping back and reevaluating what many market watchers say are unrealistic expectations. Education is a crucial first step for helping investors estimate realistic rates of return, and the risk levels associated with different types of investments. Investing is not a mystery. Instead, it is a discipline that involves reading financial magazines, books and newspapers, asking questions and seeking the advice of a financial professional.

Risk versus Return

Although diversified portfolios are generally subject to less risk, investors always face market risk (the possibility that stock or bond markets will decline over short or extended periods) and inflation risk (the possibility that investors may not earn enough on their money to keep up with inflation and preserve the purchasing power of your savings). According to Ibbotson Associates, inflation, which has historically averaged 3.1 percent, offsets much of the nominal (before inflation) returns from bonds or cash reserves. Because stocks’ real (after inflation) returns are historically much higher, they are considered an "inflation hedge," or a way to help protect savings from inflation over the long term.

In evaluating realistic returns, investors should measure performance against a target that takes into account investment objectives and risk tolerance. These differ for everyone. In addition, investors should weigh returns against the appropriate index for each sector of their portfolio. For example, the DJIA and S&P 500 are appropriate benchmarks for large-company investors. Those primarily interested in small, growth companies would get a better idea of relative performance from the Nasdaq Composite Index. Bond investors will want to look at relevant bond indices.

Clearly, experienced investors better understand the historic risk-reward tradeoff: in order to pursue higher returns, additional risk must be assumed. Case in point: PaineWebber’s Index shows that investors with more than five years of experience expect average returns of 15 percent, which is three percentage points lower than less experienced investors.

While stock and bond markets can be risky in the short term, time has a moderating effect on market, and the longer a stock or bond is held, the less chance there is of losing money. While it is only natural to be concerned after a losing period, the financial markets have provided attractive returns for disciplined, patient investors.

Consulting a professional can help both new and experienced investors determine how to benchmark investments. Likewise, investors should consider posing the following questions to a financial professional:

€ How is a client’s risk tolerance determined?

€ What risks is my current portfolio exposed to?

€ Will the returns on my portfolio enable me to meet my long-term goals?

€ When should retirement or estate planning education funding planning begin? How does risk/return play a role in these decisions?

Understanding risk as something that must be analyzed and managed, and estimating realistic rates of return on portfolios, are crucial for all investors who want to secure their financial futures.

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The information contained herein has been obtained from sources believed to be reliable, but we cannot guarantee its accuracy or completeness. Neither the information or any opinion expressed constitutes a solicitation for the purchase or sale of any security.

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Kevin FitzGerald is first vice president-Investments at PaineWebber. He focuses on the areas of professional money management, asset allocation and retirement planning. He can be reached at 1-800-654-6162 ext. 448.