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10 questions to help measure the risk in your portfolio

Reprinted courtesy of MarketWatch.com.

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Do you know how much investment risk you’re taking? Can you quantify it?

If not, this topic is worth considering. It’s hard to think of anything more important to your long-term investment success than the way you manage risk.

Most of what we read and hear and see in the financial media focuses on making money in the short and intermediate term. This is fine if your main concern is keeping score, being competitive and being sure not to lose out on whatever might give you bragging rights.

Your long-term future doesn’t depend on what happens in the short or the intermediate term. Your long-term future depends on what you do over the long haul. That’s what this column is about.

I don’t think your financial future is likely to depend on making a few bold moves. It’s much more likely to be the result of careful habits you develop to capture — and keep — the returns of the market.

The concept of “keep” is crucial because the forces of Wall Street are focused on finding ways to nibble away at your returns in the form of fees, expenses, commissions and other little charges that you’re not likely to notice. All these “little” things can really add up. If you bet everything on a few ideas or a few stocks, your bet can turn sour very quickly. Suddenly “keep” can turn into “lose.”

Preventing that is what risk management is about.

I have rarely seen a portfolio that doesn’t have obvious ways to make higher rates of return without taking more risk, or the possibility of much higher returns from taking only a small amount of additional risk.

Here are 10 questions you can use as a “selfie risk checkup” on your portfolio.

1. Are you taking too little risk and being too conservative? This may seem like prudent management, but unless you have more money than you think you’ll ever want or need (If that’s you, why are you reading this column?), you’ll need to take at least enough risk to protect your portfolio against long-term inflation.

2. Are you taking too much risk? I say the answer is probably yes if any of the following statements apply to you.

  • You think you understand the future better than most people.
  • You own at least one stock or fund in which you have enough confidence to “bet the farm” on it.
  • You can cite the profits you’ve made on your investment choices but you can’t get specific about your actual losses.

3. Do you take calls and sometimes answer email solicitations from securities salespeople? If this is you, you’re probably susceptible to sales pitches … and probably less able than most investors to afford the losses from “pump and dump” salespeople.

4. Do you know the expense ratios of the mutual funds you own, and can you justify paying the recurring costs of any actively managed funds in your portfolio? Of all of the investment rules of thumb, none has more universal agreement than this: The most dependable way to make higher returns is to pay less. The risk here is that unnecessarily high expenses will cause you to actually lose some of the returns you should be entitled to. For many people, shaving 0.5% from your annual costs isn’t very hard to do — yet it can put a lot of extra money in your pocket over the long run.

5. Do you own load funds? Paying a nominal sales commission of 5.75% is like guaranteeing that you’ll lose nearly 6% immediately, as only $94.25 of every $100 you pay will stay in your account to work for you. That loss is not actually a risk so much as a sure thing. Typically, the damage compounds itself because load funds usually have higher continuing expenses and higher turnover as well

6. Do you ever lose sleep over your investments? Do you feel compelled to pay attention to the daily financial news? If either of your answers is yes, you are certainly taking too much risk. Emotional risk is one of the biggest risks of all. TheDALBAR study may be the most obvious evidence of what happens when we let our emotions, typically greed and fear, drive our buying and selling.

7. Do you mentally separate out some small part of your portfolio, say 10%, and use that money to try to make a killing by speculating in hot funds, great ideas or what you think “everybody else is doing”? Based on everything I know, that means this part of your portfolio is likely to be subject to low liquidity, high expenses, high commissions and big implied promises. I’ve never seen any evidence that investing “for fun” or in quest of a “10 bagger” is likely to lead to good outcomes. The opposite is almost invariably true. Unfortunately, it takes far too long for many investors to wise up to this.

8. Do you understand and practice smart diversification ? If not, you are taking unnecessary risks, according to all the academic research of which I am aware. Smart diversification isn’t hard, and nearly 90 years of evidence points clearly to its payoff both in good times and bad times.

9. If you have significant amounts of money in CDs or bank savings accounts, do you take the time to shop for the best rates? I looked at Bankrate.com to find out what banks are offering on three-year CDs. These guaranteed returns range from 0.25% to 1.6%. Even the highest of those numbers won’t make you rich. But on an investment of $100,000 over one year, just the simple choice of a bank could be the difference between making $1,600 or only $250. According to my calculator, that difference is $1,350. I bet you would do a lot of comparison shopping to save $1,350 at the supermarket or when you’re buying plane tickets. So why wouldn’t you do that when you’re shopping for identical products that are all guaranteed?

10. Are you determined to beat the market? I’ve saved perhaps the most toxic risk-checkup question for last. I could write a whole book chapter on why trying to beat the market is a bad idea that’s filled with excessive risk. (Wait! I already wrote that chapter, and you can read all about it right here.)

Last fall, I wrote a column on how to turn $3,000 into $50 million for a child or grandchild. In my latest podcast, I respond to questions and comments on this topic. For more, check out my latest podcast, “Paul’s answers to your questions.”

Richard Buck contributed to this column.