Business  - Lubbock Investors must understand markets' risks

Published: Tuesday, July 21, 1998




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Tuesday, July 21, 1998 Last modified at 12:16 a.m. on Tuesday, July 21, 1998

Investors must understand markets' risks

If you closely analyze the returns produced by the S&P 500 in modern times, no consecutive three year period can match the gains attained in 1995 (37.4 percent), 1996 (23.1 percent) and 1997 (33.47 percent).

The good news for investors is that with the market's average rate of return over the past three years, money doubles every 2.3 years.

This phenomenal performance has a downside. Because of the unprecedented gains the past three years, many investors have thrown caution to the wind and are disregarding the risk associated with investing in capital markets that is the bad news.

For investors to continue to enjoy the long-term fruits of the market, they would be well served to understand the concept risk. Risk can be defined as the uncertainty of future returns.

Risk is created by price volatility; for investment purposes the two terms are interchangeable. The more volatile the price, the more the risk.

Volatility is the fluctuation of price; it is important for investors to know that volatility can be measured. Once an investor understands how to measure volatility, investment portfolios may be created that are consistent with the investor's tolerance for risk. In other words, once the volatility of a portfolio is identified, it is a simple matter to forecast, with a high degree of probability, what the worst case scenario would be. If the worst case is more than the investor can tolerate, the portfolio's volatility can be reduced.

There are two generally accepted methods of measuring the risk associated with an investment. The first is a numerical rating assigned to a stock or mutual fund based on its volatility when compared with the Standard & Poor's 500 Market Index. This numerical rating is called ''beta.'' A beta of 1.00 is assigned to the S&P 500; a rating of 1.40 indicates the investment is 40 percent more volatile than the S&P 500. There must be at least three years of performance history before a security is assigned a beta rating.

The second measurement of volatility is ''standard deviation.'' Standard deviations describe how far from the mean average the performance has been, whether higher or lower.

One standard deviation encompasses about 68 percent of the occurrences; two standard deviations cover approximately 95 percent.

The higher the standard deviation of return, the higher the risk involved with the investment. Below you will see ten-year return charts on two mutual funds. Notice that both Fund A and Fund B have the same average annual return of 12 percent. You will also notice that the yearly returns of mutual Fund B vary significantly from the average of 12 percent.

When mutual Fund A is compared to Fund B, even though the average annual rate of return is the same, the variation of yearly returns is significantly less in Fund A than in Fund B.

After studying these two charts, you may ask: Why is this important?

The importance lies in the fact that for most investors, their long-term financial goals can only be achieved by realizing a minimum average annual rate of return for a specific period of time. Portfolios that contain excessive amounts of volatility relative to the investor's ability to withstand that level of price movement will probably result in the investor liquidating the investment.

History has shown that moving in and out of the market due to the fear of a loss is non-productive. This activity is similar to ''timing'' the market. Investors who follow this practice seldom achieve the potential returns offered by the capital markets.

After enjoying the returns of the past three years many investors have unknowingly designed their investments with standard deviations that far exceed their tolerance for risk.

Many have concentrated their investments in large U.S. stocks. This is the one asset class that has far outperformed all other markets investments for the last three years.

An investor who concentrates his investment in none type of investment or asset class is essentially putting ''all of his eggs in one basket.''

All of us know this is not prudent. To achieve a satisfactory rate of return with a degree of risk that is suitable for most investors, it is essential that investors effectively diversify their investments.

Effective diversification can be achieved by combining investments in an investment portfolio that are dissimilar. The more dissimilarity present, the lower the volatility. Increasing the amount of short-term fixed income assets in your portfolio can further reduce volatility. If portfolio design is properly pursued, the investor will sacrifice little long-term gain to reduce his portfolio's volatility.

The concentration of investment dollars in a single asset class such as large U.S. stocks without regard for the risk associated with that course of action is probably a result of greed.

An old market adage states: ''Bulls make money. Bears make money. Hogs get slaughtered.'

It is is wise to remember this when you review your investments.