February 22, 2011
How should clients think about risk in their portfolios? Advisor Perspectives put that question to a cross-section of prominent advisors and academics. Their answers encompassed diverse opinions and underscored how crucial that question is to the investment process.
In part one of this series, which appeared last week, we heard from seven practitioners in the financial planning community. This week, we hear from seven well-known academics, including two Nobel Prize winners.
We asked each person the following questions:
- How should a 25-year-old, who is beginning to save for retirement, think about and measure the risk in his or her portfolio?
- How should a 65-year-old, who is beginning the withdrawal phase of their retirement, and the adequacy of whose portfolio is precarious, think about risk in his or her portfolio?
We were not asking how that person should invest, but rather how they should think about risk.
Here are their responses, in alphabetical order.
Brad Barber is the Maurice J. and Marcia G. Gallagher Professor of Finance at the University of California at Davis’ Graduate School of Management. His research focuses on investor psychology.
There is risk that you can get rid of, and there is risk that you can't. First and foremost, you want to be saving for retirement in a well diversified portfolio. The risk that you don't want to take is putting all of your hard-earned money into a single stock, for example. That sounds silly to many people, yet plenty do it, because they put a lot of their money into employee-owned stock plans.
Look at Enron, for example. About half of the average Enron employee’s retirement portfolio was in Enron stock. Investing a large proportion of your retirement portfolio in a single stock is among the biggest mistakes that an investor can make.
For somebody who is young, the crucial thing is to save. That is really hard to do, because we are very bad as human beings at thinking about what the future holds for us and what saving now will afford our future selves. There are very interesting experiments where, if you give people a picture of themselves aged into the future, it can actually affect the choices they make about how much they choose to save.
Encouraging people to think about the tradeoff between current and future needs can motivate them to increase savings early on. Regular saving and making a sensible choice in their investment portfolios – for example choosing a low-cost, well diversified investment portfolio – are the two issues I would encourage young investors to address.
How should a 65-year-old, who is beginning the withdrawal phase of their retirement, and the adequacy of whose portfolio is precarious, think about risk in their portfolio?
One of the mysteries in financial economics is that we don't see a lot of annuitization of retirement savings. For someone who is approaching retirement having saved enough to buy an annuity that makes them comfortable, I see a lot of arguments in favor of doing so. There is no reason for that person to bear the mortality risk of outliving their savings (perhaps a good problem to have, given the alternative). Buying an annuity is a sensible way of avoiding that risk altogether.
Inflation-indexed annuities are preferable, and if you feel comfortable taking on market risk, you can buy a variable annuity, which is cheaper than a fixed-rate annuity.
There are lots of products, which, frankly, may lead to the kind of paralysis that often sets in when we are faced with a complicated decision and many choices. Too many choices lead folks to opt for the status quo or, in this case, not buy an annuity and instead just withdraw from an investment portfolio.
Would you like to send this article to a friend?Remember, if you have a question or comment, send it to .