By TARA SIEGEL BERNARD
JPMorgan Chase’s giant trading loss began as an effort to manage the
bank’s risks — a move that turned into something that now looks more
like a speculative bet. But don’t think this is solely a big-bank
problem. Even small investors can run into trouble discerning the fine
line between hedging and risk taking.
Investors can try to limit
their risks by holding down their stock exposure through diversified
investments. But many people are still depending on the market’s engine —
perhaps more than they might think — to maintain a comfortable lifestyle in retirement, say, or pay for their children’s college educations.
While this strategy has worked for many people
and is considered prudent by financial advisers, it’s still a wager.
Your portfolio can take a painful nose dive just before you retire,
which means you may have to work longer (if you can) or cut spending.
But somewhere along the way, as pensions vanished and 401(k)’s took
hold, investing in stocks for retirement was viewed as a manageable
risk. After all, even after the market collapse in 2008-9, what other
choice is there?
There are other approaches to risk management,
but all of them involve their own set of trade-offs, costs and risks.
And, as in JPMorgan’s case, going too far can also create problems.
caveat to most risk management techniques is the simple acknowledgment
that, taken to extremes, they are no longer risk management techniques
but the introduction of new risks or bets themselves,” said Michael
Kitces, director of research at the Pinnacle Advisory Group in Columbia, Md., who also blogs about financial planning at Nerd’s Eye View.
approach you take is going to cost you something, even if you avoid the
stock market altogether. So how you deal with investment risk will
ultimately depend on what you’re willing to give up. Here are some
ELIMINATE MOST RISK Trying to squeeze out risk is
still going to require some sacrifices. The idea is that you save enough
money to meet your goal — say, covering your basic expenses in
retirement — without investing in risky assets. The big caveat is that
you’ll need to save aggressively, perhaps much more so than if you
turned to the stock market for some assistance (assuming it provides a
decent return during your time frame).
But some academics like Zvi Bodie,
a finance professor at Boston University, say they believe it can be
done by taking a “safety first” approach, where you start by figuring
out what your bare essentials will cost in retirement. Then, you save
aggressively to cover those expenses, and put the money into virtually risk-free investments, like Treasury Inflation-Protected Securities (TIPS) or I-Bonds.
(I-Bonds never decline in value, are issued by Treasury and pay a fixed
interest rate, currently 0 percent, as well as a variable rate that
keeps pace with inflation.)
The idea is to create a safety net
once you stop working. So if you bought $10,000 of I-Bonds each year
over a 40-year career — the maximum you can buy each year, though
Professor Bodie expects the amount will be adjusted for inflation — you
would leave the work force with $400,000. Today, a 65-year-old man could
take that money and buy an annuity that would provide roughly $15,000
in inflation-adjusted income annually (with spousal survivor benefits).
This could be used with Social Security income — for a retiree at full
retirement age today, a maximum of about $30,000 annually — to cover the
“That’s not too bad,” added Professor Bodie, co-author of “Risk Less and Prosper” (Wiley 2011).
also suggested creating something that approximated a personal pension
through a so-called TIPS ladder. Here, you would figure out your basic
spending needs each year, and buy TIPS with varying terms so that the
bonds mature over time, as you need the money. (Given the tax treatment
of TIPS, he recommended doing this in a tax-deferred or tax-sheltered
account. It also takes significant planning since TIPS are sold in
Mr. Bodie said he did not have a problem
investing money in riskier assets for discretionary spending. He also
said that younger people could handle somewhat more risk since they had
the luxury of time to make adjustments.
Still, this approach
isn’t foolproof either. You may be sacrificing more than you need to if
the markets do well. You can also lose the ability to save aggressively
if you are laid off, for example, or have an expensive medical issue.
And then there are all of life’s other costs — college tuition, saving
for a down payment on a home, health insurance.
“The trouble is,
of course, that almost no one can accumulate that much money — in rough
terms, about 25 years of living expenses after Social Security and
pensions — just by investing in safe assets,” said William J. Bernstein, author of “The Investor’s Manifesto”
(Wiley 2009) and other investing books. “You have to take some risk to
get there, and because you’re taking that risk, you may not get there.
But taking that risk is still your best shot.”
There are several
different ways to figure out how much that kind of low-risk approach may
cost you. But let’s say you decided that saving $1 million was enough
(that is, $1 million in inflation-adjusted dollars, meaning it keeps
pace with inflation over time). You may be able to get there after 30
years by saving $750 a month, or $9,000 annually, and investing that
money in a portfolio evenly split between stock and bonds, which earned
4.7 percent after inflation. But to avoid the stock market altogether,
you would have to increase your monthly savings to $1,250 a month, or
$15,000 a year, and receive a 2.5 percent return after inflation in a
diversified bond-only portfolio, according to calculations by Kent Smetters, a risk management professor at the University of Pennsylvania’s Wharton School and founder of Veritat Advisors, which takes an approach similar to the one advocated by Professor Bodie.
REDUCE RISK, LIVE WITH SOME Investing in a
diversified portfolio — split among different types of stocks and bonds,
while gradually reducing your exposure to risky stocks — is the classic
way to reduce your risk. But it doesn’t eliminate risk. “In a crunch,
or even in a normal sharply down market, like we’ve had the past few
weeks, there are only risky and riskless assets,” Mr. Bernstein said.
“So in the short term, diversification among different stock asset
classes is usually of no help. They all get taken out and get shot. But
over a decade or longer, diversification among stock asset classes is
And when you add a healthy helping of bonds, you
further reduce that risk. The trick is finding a level of risk you’re
comfortable with so that you don’t bail out at the worst possible time.
This approach also requires you to consider what a worst case might feel
like, and what sort of changes you need to make to adjust.
can also reduce your risk through hedging techniques. One relatively
straightforward strategy is buying “put” option contracts, which give
you the right to sell a fixed number of shares (say, of an
exchange-traded fund that tracks a stock index) at a certain price
within a certain period of time. This essentially puts a floor on your
losses. If the shares don’t drop, you lose only the cost of the option.
while this allows you to hedge your risk, it can weigh on your total
return because you are paying for the insurance the puts provide. The
downside, of course, are the costs and the hassles of such a strategy.
“You can approximate any hedging strategy you might want far more
cheaply simply by selling some risky assets,” Mr. Bernstein said. “There
is no risk fairy who will write you a cheap option that will take stock
risk off your hands.”
TRANSFER OR SHARE RISK This approach to
risk management typically involves buying insurance. If you’re about to
retire, you could buy a single-premium immediate annuity,
where you pay an insurance company a pile of cash and, in return, the
company pays you a stream of income for the rest of your life. The
downside is that you just surrendered a pile of cash, which means you
will not be able to use that money in an emergency. And if you die
prematurely, your heirs won’t receive it either. There’s the risk, too,
that the insurance company could run into financial trouble.
can also feel expensive. They may pay out approximately 4 or 5 percent
of your investment, according to Professor Bodie, depending on the
options you choose. An investment of $500,000 will buy slightly less
than $2,400 in monthly income for a 65-year old man and his 62-year-old
wife, according to a rough estimate from ImmediateAnnuities.com. But inflation-adjusted payments will cost more.
insurance is going to cost you,” said Professor Bodie, who says he
believes annuities may make sense for some retirees. “There is no free