INVESTMENT RISKS:
Managing Greed and Fear

Last autumn I met a man who had investments of $1.7 million, all of it in bonds and certificates of deposit. He was concerned about the low interest rates he was getting, and he attended one of my workshops. He came away quite impressed with the Worldwide Balanced Portfolio that we recommend to so many people.

About the start of 2001, this retiree became a client, giving us $125,000 of his money to manage in that strategy, which is invested 25 percent in U.S. equity funds, 25 percent in international equity funds and 50 percent in bond funds. Every asset is defensively managed with market timing, and that appealed to him.

RISK IS NOT IMPOSED ON YOU FROM OUTSIDE. IT'S SOMETHING YOU CHOOSE AND ACCEPT.

We talked for more than 90 minutes as he opened his account. Because he was used to the complete safety of CDs, much of the discussion was about investment risk. We talked about the possibility that in the short term he could sustain losses from being in equity and bond funds. He was quite comfortable with that notion, and together we decided that he should not have much trouble with exposing about 7.5 percent of his portfolio to a moderate amount of risk.

He understood that the Worldwide Balanced Portfolio has a built-in one-year loss expectation of 6 percent, and he said he accepted that. We discussed the possibility that he might get nervous, but he assured me he would ride out the short-term ups and downs while he sought the long-term objective of leaving a more substantial estate to his heirs.

Soon after he opened his account with us, the stock market turned ugly. In the first quarter of the year, the Standard & Poor's 500 Index fell 12.1 percent and the Nasdaq Index lost a stunning 25.5 percent. As this was happening, the financial news seemed to portray an ever-gloomier outlook.

Our office started getting frequent calls from this client, who was as nervous as a cat while watching the market dive. (When he opened the account, I had sensed his nervousness, but he had assured me in advance that he wouldn’t be a frequent caller.)

Three months after he opened his account, my client’s balance had declined by less than $1,000. Because of our timing systems, only $17,000 of his money – one-tenth of 1 percent of his whole portfolio – was exposed to equity funds. The rest of the money we managed for him was in bonds and a money-market fund.

The client called in great distress. I remember he said: “I feel like it could go down forever.” He understood that his fear was irrational, but that didn’t stop him from worrying that his $125,000 investment would somehow infect everything he had worked for and saved. His experience was of raw fear, unhindered by facts.

The anguish was just too much for him, and he closed his account after losing half a percent of his Worldwide Balanced Portfolio during a time when the stock market was down by 10 percent.

What’s the lesson here? I’m not sure, exactly. We focused on risk in our discussion. We educated him. We certainly did not expose any significant part of his portfolio to the possibility of loss. We did all the right things, and in this case he – and we – discovered later that he simply didn’t belong in the equity markets.

Perhaps the lesson is that risk is at least as much emotional as it is objective and quantitative.

I’ve been in the investment business since the 1960s and I have spent many hours thinking about, reading about and talking about managing risks. I know it’s one of the most important parts of being a successful investor.

Here’s something that we wrote to our clients in 1998 and again in 2000:

“In the very good times, it seems as if investing is about accepting wealth. You put down your money, almost like planting it in a garden, and watch it grow. But in fact, in good times and bad, investing is really about managing risk and managing your emotions. If you want to be a successful investor, you’ve got to do at least a decent job at both those tasks.”

Yet despite our best efforts over many years, I’m still disappointed that we haven’t mastered the management of emotional risks. In a way, this is the most difficult part of investing.

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