Financial professionals working with clients will typically try to establish a client's attitude toward risk by doing a risk tolerance survey. The survey establishes a client's ability to accept volatility in his or her investment portfolio. The adviser is also interested in establishing the client's capacity to accept risk in the portfolio. Capacity considerations deal with the client's net worth and income.
Investors want to be compensated for taking on risk. To that end, risky investments should have higher expected returns than safer, less volatile investments. It's the expected part that is so crucial. If no one expected stocks to return more than certificates of deposit, recommending stocks as investments would be a difficult task.
Investors have to expect the stock market to outperform a low risk asset to be willing to invest in stocks. Sometimes, as in 2008, the expectations aren't met. In 2008, the total return on the Standard & Poor's 500 index was down 37 percent. In contrast, in 2013, the total return was up 32.39 percent. Because they don't know the future, investors, on their own or with their adviser's help, need to figure out how much bad news they can take.
Here's where the Federal Reserve comes in. With its easy money policy, including three rounds of quantitative easing, the financial markets have been awash in liquidity since the financial crisis. That keeps short-term interest rates low. With minimal inflationary pressures, longer-term interest rates, while up about a percent since last May, are still low, too. The 10-year Treasury note was at 1.66 percent in May 2013 and is, at this writing, 2.65 percent.
With low risk investments having such low returns, yield-oriented investors move into riskier investments in an attempt to capture a higher return. That bids up the price of these riskier investments.
While I'll be the first to tell you that I can't forecast where markets will be at the end of the year, I do worry about continued gains coming from investors moving from low-risk investments into the stock market, even as Federal Reserve Chair Janet Yellen assures Congress that short-term interest rates will remain low over the next year or two.
Has your investment strategy changed while the Fed has kept rates low?
Follow me on Twitter: @drdonsays.