Do you consider yourself a financial risk-taker? If so, what is the standard that you use to analyze risk? If you don't fully understand risk, you may be looking at the wrong criteria to make the best financial decisions for you and your family.
A recent survey by AMG Funds suggests that very few investors understand how to assess investment risk accurately. Only 9% of survey respondents correctly chose the proper metrics to assess investment risk from this list: Standard Deviation, EPS, P/E ratio, Beta, Yield, or None of These Choices. Which would you choose?
If you chose Standard Deviation and/or Beta, you are one of the 9% that AMG would call a knowledgeable investor. If you chose other factors – or worse, don't understand what the factors even mean – let's do a quick review.
Earnings per share (EPS), price-to-earnings (P/E) ratio, and yield are all measures of an individual stock at a particular point in time. EPS and P/E ratio are measures of how corporate earnings compare to the number of outstanding shares and the current stock price respectively. Yield refers to the annual dividends that a stock provides relative to its price (on a per share basis).
The other two values measure a stock's performance over time. Standard deviation is a measure of how much the return of a stock varies over time. Beta measures how much a stock's return tends to change with swings in the overall market. These two factors allow you to calculate risk – the odds that any stock's return will be different than the expected value – as well as giving you an idea of the possible rewards associated with that risk.
Risk can come from many factors, from overall market risk to business-specific financial risk. Global factors such as political and currency risks also come into play. By using standard deviation and beta, all of these factors are incorporated as much as possible via past performance.
Risk assessment is essential to meeting your retirement goals. If your portfolio is too conservative, your returns may be solid and predictable but insufficient to meet your needs. Conversely, a portfolio that relies on high-risk, high-return stocks could collapse near retirement, leaving you no time to recover.
You should strive for a balanced portfolio based on your retirement goals and tolerance for risk. However, less savvy investors may lack the understanding to take advantage of risk opportunities – for example, the AMG survey found that only 21% of unknowledgeable investors consider a 20% drop in stocks as a buying opportunity.
Survey respondents were split on the preferred style of advisor. Six distinct categories were preferred by 12% to 20% of respondents – the "Personal Trainer" that provides focus, the "Commander-in-Chief" that handles everything, the "Collaborator" that shares ideas, the "Bodyguard" that protects nest eggs, the "Doctor" who provides on-call advice when needed, and the "Interpreter" who can make financial options clearly understandable.
This may reflect the sometimes-contradictory nature of Millennials as they embark on their investing careers. Millennials appear to be generally risk-averse and have more faith in computer-generated portfolios. 63% of Millennials consider such portfolios less risky than those compiled by humans, and 70% believe they provide better returns (compared to 17% and 14% respectively for older generations) – yet 83% are disappointed that computer-generated portfolios don't provide specialized advice. Over three-quarters (77%) of Millennials prefer that a dedicated contact person be available to answer their questions, and they expect almost twice the number of interactions with their advisors compared to Baby Boomers.
Are Millennials afraid of risk because they don't understand it? The survey does not speculate on that topic. However, a full understanding of risk is best regardless of your risk tolerance level.
What's our advice? Be a financial risk taker – but do it responsibly and with the proper understanding of financial risk factors. As Millennial Money Expert Stefanie O'Connell puts it, "Investing does have risks, but ... it's one of the most effective ways of building your wealth in the long term."
If you don't fully understand risk, don't pretend that you do. Seek advice from a qualified source to fill in any gaps in your education. Your family's financial security is too important to leave to undereducated guesses.
Let the free Retirement Planner by MoneyTips help you calculate when you can retire without jeopardizing your lifestyle.