Blogs > Your Money

Dave Patterson and Erin Preston, a father-daughter team of Certified Financial Planner® licensees, provide thoughts and suggestions on a broad collection of personal finance topics.  Information provided in this BLOG is intended to be of a general nature and may not be appropriate for all situations.  Readers should consult with their own financial advisors before relying on any information contained herein.

Thursday, September 24, 2009

We May Need to Re-Think Our Tolerance for Risk

An article I read recently in the Wall Street Journal discussed the traditional use of the “normal curve” for determining the risk of investing in stocks. If you aren’t sure what the “normal curve” is, think back to your high school days and how the teachers graded. If they graded on the “curve”, they were using the normal curve to distribute grades in a manner that would be consistent with what one would expect for a “typical” class. The graph of a “normal” distribution is the normal curve. Most grades are clustered around the mean (a C grade), fewer for B’s and D’s, and a very few for E’s and A’s.

Investment advisors have traditionally assumed that stock returns have the characteristics of a normal distribution over time. From a statistical standpoint, this allows them to predict a range of returns over time based on the long term return of stocks and the variability of those returns, which is called the standard deviation.

For stocks, the long term return has been around 10% and the standard deviation 21%. Using the normal curve, we can therefore predict that stock returns will fall in a range of 10% plus or minus 21%, approximately two-thirds of the time. In other words, about 67% of the time, stock returns will be between -11% and +31%. The other one-third of the time, the returns can be expected to be worse than -11% or better than +31%.

Clearly, the last couple of years we’ve seen the extreme case where stock returns have been below -11%. Some have said that the current economic crisis is a one-in-a-hundred year event. And when you consider that less than 10 years ago in 2000 and 2001, we also had an extreme downturn, you might begin to wonder if the statistical model we are using for stock returns may not accurately reflect the downside risk. It seems that economic crises are happening more often.

Regardless, it still makes sense to ensure you have a broadly diversified portfolio. And, we still think it’s crazy to try to time the market. In light of the extreme volatility we are now seeing, we think investors should make sure they are not taking on more risk than they need to in order to achieve their goals. And just in case more crises are coming down the road, you may want to rework your budget with the aim of increasing savings.
Additional savings allows you to increase your wealth without taking on unnecessary risk.


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