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QUARTERLY REVIEW & OUTLOOK

Rethinking the Game Plan

Many investors have learned the hard way that risk is not always rewarded and that some market 'truths' are only half-truths.

October 07, 2002|KATHY M. KRISTOF | TIMES STAFF WRITER

There's nothing like a bear market to test an investor's ability to tolerate risk.

Stuart Siegel, a 47-year-old Los Angeles resident, readily admits he failed that test.

"I think I'm pretty typical," Siegel said. "My thought was to be aggressive, earn as much as possible and retire early. I was reaching for the moon."

Now Siegel is fixated on how to protect his nest egg from additional losses--not just in the near term, but in bear markets that may be far in the future.

"I lost 45% to 48% of my portfolio before I realized that I don't have the stomach for this," Siegel said. "I will never do that again."

As the longest market decline since the Great Depression ground its way through the third quarter, millions of Americans learned the same cruel lesson. Following advice about how much risk the "average" investor should be willing to accept in return for stock market rewards, they discovered too late that they aren't "average."

As a result, Southland financial planners say, 5% to 30% of their clients have pulled out of the stock market in recent months rather than face the prospect of further losses. And the planners are loathe to stop them, even though many believe that stock prices are, finally, getting close to a bottom.

These planners, who once thought young investors with lots of time could handle lots of risk--particularly when these investors described themselves as risk tolerant--now think that they and their clients underestimated their threshold for pain.

"The market is showing us that the reality of living through a bear market is a lot different than reading about it in a book or financial magazine," said Christopher Orndorff, managing principal at Los Angeles investment firm Payden & Rygel.

The number of people bailing out of stocks--investors on balance pulled money out of equity mutual funds at a record pace this summer--has taught planners that they need to be more forceful when explaining market risks to their clients.

Classic asset allocation models, which typically recommend that investors have a significant percentage of their money in stocks even as they approach retirement, are still valid, planners say.

But some also say they have become less inclined to talk their clients out of portfolios that the planner might consider too conservative, assuming the stock market will someday recover.

"I do believe that asset allocation will work long-term. The problem is that the stomach cannot always handle the long term," said Linda A. Barlow, a financial planner in Santa Ana. "We don't deal with computers. We deal with live bodies, and they are having a hard time holding on."

Many investors have been victimized by their faith in market "truths" that turned out to be half-truths. If you're trying to develop an investing game plan that reflects the lessons learned in the last two years, without becoming overly fearful of the future, recognizing these half-truths may help you prepare yourself for whatever markets bring next:

Half-truth: Risk and reward go hand-in-hand.

Real truth: Only some risks are rewarded.

Throughout the 1980s and 1990s, investors were both warned about stocks and lured into them with the promise that financial markets reward those who take risks, said Christopher Jones, executive vice president of financial research and strategy with Financial Engines, an investment Web site based in Menlo Park, Calif.

"But there are good risks--the kind that you get compensated for--and there are bad risks," he said. There still is ample reason to believe that, over time, you will be fairly compensated for taking the risk of owning a diversified portfolio of stocks. But the odds are far lower that you'll be well-rewarded for the risk of holding just one stock (say, your employer's), or a portfolio concentrated in one industry.

This is the trap that snared Siegel. He thought the risk of being 100% invested in a mix of technology stocks was just a bit higher than the risk of being fully invested in a diversified portfolio of stocks. Moreover, he thought his portfolio would perform better, on average, over time, because he was taking more risk than the average well-diversified investor.

"It's the concept of no-pain, no-gain," said Alan Skrainka, chief market strategist at brokerage Edward Jones & Co. in St. Louis. "But the risk-reward principle only applies to diversified asset classes and only over a long period of time."

Despite many investors' temptation to keep shrinking away from equities, Skrainka argues that each additional losing month in the market boosts the odds that new buyers will be well-compensated for the risk they're taking, over the long run.

When you are surrounded by bad news--the country may go to war; Wall Street and Main Street are beset with scandal; corporate profits are down; the economy is tenuous--investors perceive the stock market as being a very risky place. As a result, stock prices are lower, and their potential for appreciation is greater, Skrainka said.

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