By TARA SIEGEL Published: May 18, 2012JPMorgan Chase’s giant trading loss began as an effort to manage the bank’s risks — a move that turned into something that now looks more like a speculative bet. But don’t think this is solely a big-bank problem. Even small investors can run into trouble discerning the fine line between hedging and risk taking.
Robert Neubecker
Bucks
Managing the Risk in Your Investment Portfolio
What sort of approach do you take to limiting the risk in your investment portfolio? Have you ever tweaked your approach because you realized you were taking too much or too little risk?
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Tara Siegel Bernard
is a personal finance reporter with The Times.
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Investors can try to limit their risks by holding down their stock exposure through diversified investments. But many people are still depending on the market’s engine — perhaps more than they might think — to maintain a comfortable lifestyle in retirement, say, or pay for their children’s college educations.
While this strategy has worked for many people and is considered prudent by financial advisers, it’s still a wager. Your portfolio can take a painful nose dive just before you retire, which means you may have to work longer (if you can) or cut spending. But somewhere along the way, as pensions vanished and 401(k)’s took hold, investing in stocks for retirement was viewed as a manageable risk. After all, even after the market collapse in 2008-9, what other choice is there?
There are other approaches to risk management, but all of them involve their own set of trade-offs, costs and risks. And, as in JPMorgan’s case, going too far can also create problems.
“The caveat to most risk management techniques is the simple acknowledgment that, taken to extremes, they are no longer risk management techniques but the introduction of new risks or bets themselves,” said Michael Kitces, director of research at the Pinnacle Advisory Group in Columbia, Md., who also blogs about financial planning at Nerd’s Eye View.
Whatever approach you take is going to cost you something, even if you avoid the stock market altogether. So how you deal with investment risk will ultimately depend on what you’re willing to give up. Here are some different approaches:
ELIMINATE MOST RISK Trying to squeeze out risk is still going to require some sacrifices. The idea is that you save enough money to meet your goal — say, covering your basic expenses in retirement — without investing in risky assets. The big caveat is that you’ll need to save aggressively, perhaps much more so than if you turned to the stock market for some assistance (assuming it provides a decent return during your time frame).
But some academics like Zvi Bodie, a finance professor at Boston University, say they believe it can be done by taking a “safety first” approach, where you start by figuring out what your bare essentials will cost in retirement. Then, you save aggressively to cover those expenses, and put the money into virtually risk-free investments, like Treasury Inflation-Protected Securities (TIPS) or I-Bonds. (I-Bonds never decline in value, are issued by Treasury and pay a fixed interest rate, currently 0 percent, as well as a variable rate that keeps pace with inflation.)
The idea is to create a safety net once you stop working. So if you bought $10,000 of I-Bonds each year over a 40-year career — the maximum you can buy each year, though Professor Bodie expects the amount will be adjusted for inflation — you would leave the work force with $400,000. Today, a 65-year-old man could take that money and buy an annuity that would provide roughly $15,000 in inflation-adjusted income annually (with spousal survivor benefits). This could be used with Social Security income — for a retiree at full retirement age today, a maximum of about $30,000 annually — to cover the basics.
“That’s not too bad,” added Professor Bodie, co-author of “Risk Less and Prosper” (Wiley 2011).
He also suggested creating something that approximated a personal pension through a so-called TIPS ladder. Here, you would figure out your basic spending needs each year, and buy TIPS with varying terms so that the bonds mature over time, as you need the money. (Given the tax treatment of TIPS, he recommended doing this in a tax-deferred or tax-sheltered account. It also takes significant planning since TIPS are sold in five-year maturities.)
Mr. Bodie said he did not have a problem investing money in riskier assets for discretionary spending. He also said that younger people could handle somewhat more risk since they had the luxury of time to make adjustments.
Still, this approach isn’t foolproof either. You may be sacrificing more than you need to if the markets do well. You can also lose the ability to save aggressively if you are laid off, for example, or have an expensive medical issue. And then there are all of life’s other costs — college tuition, saving for a down payment on a home, health insurance.
“The trouble is, of course, that almost no one can accumulate that much money — in rough terms, about 25 years of living expenses after Social Security and pensions — just by investing in safe assets,” said William J. Bernstein, author of “The Investor’s Manifesto” (Wiley 2009) and other investing books. “You have to take some risk to get there, and because you’re taking that risk, you may not get there. But taking that risk is still your best shot.”
There are several different ways to figure out how much that kind of low-risk approach may cost you. But let’s say you decided that saving $1 million was enough (that is, $1 million in inflation-adjusted dollars, meaning it keeps pace with inflation over time). You may be able to get there after 30 years by saving $750 a month, or $9,000 annually, and investing that money in a portfolio evenly split between stock and bonds, which earned 4.7 percent after inflation. But to avoid the stock market altogether, you would have to increase your monthly savings to $1,250 a month, or $15,000 a year, and receive a 2.5 percent return after inflation in a diversified bond-only portfolio, according to calculations by Kent Smetters, a risk management professor at the University of Pennsylvania’s Wharton School and founder of Veritat Advisors, which takes an approach similar to the one advocated by Professor Bodie.
REDUCE RISK, LIVE WITH SOME Investing in a diversified portfolio — split among different types of stocks and bonds, while gradually reducing your exposure to risky stocks — is the classic way to reduce your risk. But it doesn’t eliminate risk. “In a crunch, or even in a normal sharply down market, like we’ve had the past few weeks, there are only risky and riskless assets,” Mr. Bernstein said. “So in the short term, diversification among different stock asset classes is usually of no help. They all get taken out and get shot. But over a decade or longer, diversification among stock asset classes is nearly magic.”
And when you add a healthy helping of bonds, you further reduce that risk. The trick is finding a level of risk you’re comfortable with so that you don’t bail out at the worst possible time. This approach also requires you to consider what a worst case might feel like, and what sort of changes you need to make to adjust.
You can also reduce your risk through hedging techniques. One relatively straightforward strategy is buying “put” option contracts, which give you the right to sell a fixed number of shares (say, of an exchange-traded fund that tracks a stock index) at a certain price within a certain period of time. This essentially puts a floor on your losses. If the shares don’t drop, you lose only the cost of the option.
So while this allows you to hedge your risk, it can weigh on your total return because you are paying for the insurance the puts provide. The downside, of course, are the costs and the hassles of such a strategy. “You can approximate any hedging strategy you might want far more cheaply simply by selling some risky assets,” Mr. Bernstein said. “There is no risk fairy who will write you a cheap option that will take stock risk off your hands.”
TRANSFER OR SHARE RISK This approach to risk management typically involves buying insurance. If you’re about to retire, you could buy a single-premium immediate annuity, where you pay an insurance company a pile of cash and, in return, the company pays you a stream of income for the rest of your life. The downside is that you just surrendered a pile of cash, which means you will not be able to use that money in an emergency. And if you die prematurely, your heirs won’t receive it either. There’s the risk, too, that the insurance company could run into financial trouble.
Annuities can also feel expensive. They may pay out approximately 4 or 5 percent of your investment, according to Professor Bodie, depending on the options you choose. An investment of $500,000 will buy slightly less than $2,400 in monthly income for a 65-year old man and his 62-year-old wife, according to a rough estimate from ImmediateAnnuities.com. But inflation-adjusted payments will cost more.
“Any insurance is going to cost you,” said Professor Bodie, who says he believes annuities may make sense for some retirees. “There is no free lunch.”
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