Ease risk worries by diversifying

Published 9:00 pm Saturday, March 27, 2004

Financier J.P. Morgan Jr. gave this astute advice at the turn of the century, after a friend complained he was losing sleep as the value of his equity portfolio fluctuated widely: "Sell down to your sleeping point."

For many, a clear understanding of risk may not become apparent until after experiencing an especially volatile market environment. In fact, the nature of risk may be one of the most difficult concepts investors wrestle with while determining an investment strategy.

Evaluating these considerations may help determine your personal "sleeping point."

Rates of return on financial assets can vary greatly on a year-to-year basis, but the longer assets are held, the closer the returns approach the historic averages. Since 1926, large-cap stocks have given investors an annualized return of 10.7 percent. However, for the period between 1900 and 2000, returns for equities held just one year and adjusted for inflation, have ranged from -38 percent to +52 percent.

Lengthen that holding period to 10 years, and the range falls to -4 percent to +18 percent. When you understand the time horizon necessary to reach your financial goals, you can then use it to your advantage. The type and mix of financial assets may change greatly once you consider you have 25 years until retirement, versus enjoying those golden years around the corner.

An oversized position in one or two stocks can magnify the business risk inherent in equities. Diversifying your investment dollars across as few as 15 equities and four to five industries allows investors to approach a more market like level of risk, significantly reducing the business risk of individual equities.

This strategy also allows the positive impact of superior stock selection to build wealth over time. Creating wealth is a matter of understanding the risks under your control, namely time and diversification. While you can’t diversify away from market risk, investors who are less risk tolerant can manage that risk through increased holdings in lower risk assets, generally bonds and cash.

For investors with a long-term time horizon and good diversification, accepting above average market risk may be advisable, for the potential of above average returns.

You are the best judge of how you react when your portfolio fluctuates. It’s all too human to become overconfident when times are good and overly pessimistic when the market or economy hits a rough spot.

As Plato said, "Know thyself." How do you react to change? What premium do you place on predictability? Which outcome is more compelling: a 25 percent chance of winning $1,000 or a 75 percent chance of winning $250?

Analysis of these considerations is likely to give you stronger perspective on the potential to reach your financial goals, given the commensurate levels of investment risk. Like Mr. Morgan’s friend, if you’re losing sleep, it may be a signal to re-evaluate the level of risk you are really willing to assume.

Jim O’Neil is an investment executive with Dain Rauscher Inc., a member, NYSE and SIPC. These answers are for informational purposes only and should not be considered a recommendation to buy or sell any security.