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Risk and the nervous investor

By Sheyna Steiner ·
Friday, July 22, 2011
Posted: 11 am ET

When it comes to investing there are many types of risk -- liquidity risk, interest rate risk, inflation risk, just to name some of the biggies. But the one people think of most when talking about risk is market risk or volatility. It refers to the ups and downs that move stock prices on a daily basis and is represented by a stock's beta.

The Standard & Poor's 500 index has a beta of one. Stocks and stock mutual funds with a higher beta tend to gain more and lose more than general market. Those with a beta of less than one tend to move less.

Short-term volatility dominates most stock market coverage in the news and can lead to unnecessary skittishness for some investors and that can hamper long-term growth.

Advisers can also unwittingly focus too much on the short-term in their quest to manage risk, according to a blog post this week on, "What behavioral finance teaches on how to discuss risk with clients."

The reason for this over-emphasis on controlling volatility is explained by behavioral finance. In the well-known research paper “Myopic Loss Aversion and the Equity Premium Puzzle” authors Shlomo Benartzi and Richard H. Thaler examine investor appetite for stocks and bonds given the historical discrepancy of their returns. While stocks have pulled in annual real returns of about 7% since 1926, according to Ibbotson research, Treasury bills have earned less than 1%. Such a large chasm in performance raises the question: why would anyone prefer holding on to short-term bonds?

Their answer: Losses hurt more than gains feel good.

Monitoring performance at too-frequent intervals often leads to irrational and unnecessary volatility worries. The net result of these behavioral patterns is too much time spent thinking about and feeling the effects of the downside and not enough thinking about potential gains, despite the fact that gains are what will ultimately lead investors to meet their financial goals.

Of course investors with a short time horizon do benefit from more zealous downside management -- that's why the portfolio of a retired 80-year old will be quite different from that of a 30-year old worker.

One solution that addresses the many different types of risk is a solid asset allocation plan and diversification.

What do you think?

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