Educational Programming Video
The Value Line Mutual Fund Survey
Program 15: Financial Planning Part 4
In this lesson we'll continue our discussion on financial planning. In the last three sessions we created a foundation for a financial plan. You know your starting point from calculating your net worth, you know how much you have to save from your budget, and your goals tell you where you want to go. Now the big issue. How are you going to get there.
As with any trip, there are a number of different ways to reach a destination. To get to Tampa, Florida from West Orange, New Jersey, you could fly, take a train, or drive. For those who are afraid of flying, a train might make more sense. Travelers on a budget might take a bus or drive themselves. The way people travel depends on their unique personal characteristics. Investing is the exact same way.
One of the most important aspects of investing is the amount of risk you are willing or capable of handling. For some investors, a high-risk technology fund would keep them awake all night, while others might relish the volatile nature of the tech industry. The key point is to figure out for yourself how much risk you are willing and able to handle. For that, you need to know a little bit more about risk.
Indeed, the evaluation of any investment often begins with an assessment of risk. Investors must consider their tolerance for risk and weigh it against the desire to achieve their specific financial goals.
Identifying risk, which can be defined as the uncertainty of achieving a desired return, is difficult. An investor seeking a higher return must be willing to tolerate a higher level of risk in order to have a chance of achieving that desired return. By contrast, someone willing to accept a lower rate of return has a higher probability of achieving his or her objective. A key aspect to evaluating risk is the investor's time horizon. This is why setting goals goes hand in hand with the time frame for reaching your goals.
Investors with long horizons, such as the goal to have a million dollars by the time they retire in 20 or 30 years, can afford to assume a higher level of risk, since there is a greater chance that, over time, the investment will pay off. Investors with shorter horizons, like $50,000 for a down payment on a house next year, should choose lower- risk investments, since they may not be able to wait out a period of poor investment performance.
But, lets get more specific.
In general, there are two types of risk: market risk and unique risk. Market risk is the degree to which a security's behavior is related to the overall behavior of the stock or bond markets. If an equity mutual fund, for example, behaves in a fashion similar to the overall stock market, it is said to have a high degree of market risk. If the market declines, there is a strong likelihood that the fund's value will decline as well.
Unique risk pertains only to a particular security. It is independent of changes in the stock market. For a bond, credit risk is unique risk, since a bond's credit rating is solely a function of the issuer's financial condition.
In assessing the level of risk that is acceptable, investors must consider their investment portfolio in its entirety and understand that the risk of certain types of investments can be reduced, even significantly, through diversification.
The most commonly used measure of market risk is beta. Beta is defined as a statistical measure of a security's volatility relative to the broader market. For a stock fund, beta is measured against the S&P 500, which is deemed to equal 1.00. A fund with a beta of 1.00 would be expected to move in lock step with the S&P Index. If the S&P goes up, so does the fund. If the S&P goes down, the fund does too. A beta higher than 1.00 means the fund should experience greater sensitivity to swings in the market, while a beta of less than 1.00 means the fund should show less sensitivity.
For example, a fund with a beta of 1.5 can be expected to rise (or fall) by 15% for each 10% gain (or loss) in the S&P 500. Note that beta is less useful as a risk measure with respect to certain types of funds, such as international, metals, and specialty funds, whose performance sometimes bears little relationship to the movement of the S&P 500.
Unique risk is more difficult to get a handle on, but a good proxy is standard deviation. Standard deviation shows the degree of variation in a fund's returns. For example, a fund with a standard deviation of 10 can be expected to produce an annual return that is within 10 percentage points (plus or minus) of its average annual return two-thirds of the time. Value Line measures standard deviation using monthly observations, but expresses the result on an annualized basis.
Now that you understand some of the risks involved in investing, it's time to take a look at yourself and decide how much market and unique risk you can accept. That, however, will have to wait until next session.