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This post is part of a series where personal finance expert Dan Solin looks at money moves that may seem smart in tough economic times, but are actually quite dumb. See all 12.Almost everyone has taken a big hit in this bear market. Many investors are tempted to take more risk with their portfolios to make up for their losses.
This is a bad idea.
Your asset allocation, the division of your portfolio between stocks and bonds, accounts for as much as 100% of the level of your returns, according to one prominent study.
Your asset allocation is determined by your ability to withstand market volatility. In large part, it is determined by the amount of time you can keep your assets invested without withdrawing a substantial portion (20% or more) of them.
The fact that you may have lost money in the current markets does not mean that you are able to take more risk. In fact, it may mean the opposite: Your ability to withstand market losses has diminished.
Remember that "risk" means "volatility." When you take on more risk, you are increasing volatility. Volatility is a two way street. It moves both up and down.
For many investors, taking on more risk means concentrating an investment in one or a few stocks. Of course, you could hit a home run and score big. However, it is far more likely that you will increase your risk significantly but will not increase your returns over those that you would receive if you just invested in a low cost index fund of comparable risk.
For example, AT&T is one of the 500 stocks that make up the S&P 500 index. If you had invested in AT&T for the twenty year period from 1988-2007, you would have had an average annualized return of 11.52%, with a risk (as measured by standard deviation, which calculates volatility) of 24.20%.
However, if you had simply purchased an S&P 500 index fund during the same period, your returns would have been just about the same (11.63%) but with a standard deviation of only 13.48%!
Most investors do not understand risk, much less how to calculate it. All you really need to know is that you do not want to assume more risk due solely to the fact that you have market losses. If you do, the odds are that you will increase your possibility of more losses, without increasing the likelihood of higher returns.
Dan Solin is the author of The Smartest Investment Book You'll Ever Read (Perigee Books, 2006) and The Smartest 401(k) Book You'll Ever Read (Perigee Books, 2008).
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