Thursday, December 16, 2010

Table Talk

Families gather around a table to catch up on events of the day. Table Talk is Dan Danford’s way of keeping family and friends informed about Family Investment Center and related topics.

By: Dan Danford, MBA, CRSP of Family Investment Center

Do you like to eat? Imagine a buffet where every customer is routed to a different line according to a pre-purchased ticket. Some customers enjoy traditional fare while others choose from the world's most delicious and exotic treats -- succulent lobster, prime angus beef, exotic side dishes, and luscious desserts.

Now, for sake of illustration, assume all meal tickets cost the same amount. Also, to emphasize my coming point, imagine that each buyer chooses the preferred line in advance, and for two entire weeks. Last, there's no deviation from the ticket once bought; i.e., no outside food or drink for two entire weeks (you reach an irrevocable food decision at the time of purchase).

Nearly everyone chooses the gourmet line, right? A seemingly simple decision. Of course, it can't be that simple because life isn't that simple. Instead, insert this bit of suspense into the process. A certain number of randomly selected diners will eat dog food. Not once or twice, but for the entire two weeks. And the odds differ depending on which ticket you choose -- one in ten traditional diners get Alpo, one in three gourmet diners. Over a year, there may be streaks of winners or losers, but the odds hold in the end. One in ten, or one in three.

At mealtime, lucky diners from both lines enjoy tasty, rounded meals. They happily discuss their good fortune, although some traditional eaters are openly envious of the gourmet fare. Occasionally, someone complains a bit, wishing they'd been smart enough to choose a gourmet ticket. In a distant corner, randomly selected losers sit dejectedly munching dog biscuits.

So, what's your choice? Traditional or gourmet meal ticket? Same cost, what's it going to be?

Seriously, is it worth extra risk to order gourmet food? In my example, a gourmet ticket increases your downside risk by over three hundred percent (from one in ten to over three in ten). With these odds, I'm guessing that most rational people (hypothetical in my example) will choose the traditional ticket.

So I am puzzled to watch people (non-hypothetical now) flock to high-risk, high-return market sectors. As we invest, we choose between options offering a variety of risk and return outcomes. Every decision faces an unknown outcome, although history provides some helpful hints about risk and reward. It is clear that some investment choices create greater opportunity to lose money. There are obvious streaks (we may have witnessed the longest winning investment streak ever), but, still, some investments offer a much higher potential for loss.

One measure of investment risk is a factor called Beta. Don't worry about the math, here, but realize that a Beta Coefficient is calculated for most stocks and mutual funds (ask your advisor). A Beta of 1.00 (perfect correlation) means that the security (either stock or fund) has moved exactly with the market (an index) during some measurement period. The market index went up five percent, and the security followed by rising five percent, too. The same exact percentages when the market moved down.

A high Beta (1.20) indicates that the security moved twenty percent more than the market -- both up and down. Lower Betas (.80) show the security moved less than the market (again, by twenty percent).

Now, Beta isn't foolproof (nothing is), but a high Beta mutual fund has fluctuated much more during the measurement period than a low Beta fund. So, chances of a bad outcome are much higher because downward fluctuations are so repulsive to investors. Usually, lower Betas result in lower overall performance. But, it's because risks are probably lower, too (based on past history).

Investors today don't seem to understand that a market (or stock, or fund) up hundreds of percent in twelve short months owns a very different risk profile from other options. It's not less risky because of recent performance, but almost certainly more so. If you doubt me, check the Beta for those highflying stocks or funds. It's okay to consider or even buy such investments, but you must know that your chances of sitting alone rise with this choice. Maybe rise a whole lot. Consider them for your $2,000 IRA contribution, perhaps, but not the entire kid's college fund.

Okay, the dog food illustration is overly dramatic. But the point is to explain risk in an understandable way and to suggest that there are very different potential risks -- measurable risks --for the choices we consider. One thing stands true from the illustration, when we approach the market with $10,000, the entry price is the same for either choice. We can buy $10,000 of a conservative choice or $10,000 of a riskier choice. It's the outcome that might differ.
Chances are good that we'll enjoy a favorable outcome with either choice. But, the chances of eating dog food are much higher with some choices than others. Risk and reward are absolutely related; the higher the potential gains, the higher the chance of losing money. It really is that simple.

If you'd like professional evaluation of risk in your portfolio, give us a call. Our objective research compares thousands of stocks, bonds, and mutual funds. We can help!

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