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In the second quarter of the year, investors have watched the markets swing back and forth. The Dow Jones industrial average dropped from 11,642 on May 6 to 10,706 on June 13, only to recover somewhat to end the quarter at 11,150. This reminder of market volatility gives you an opportunity to evaluate the risk in your portfolio. Even if you’ve seriously thought about this before � and many investors have not � traditional measures of risk, including an examination of historical returns and bell-curve models, can understate your true exposure. For those who pick stocks chiefly in hopes of making the next big killing, risk may not be a big concern. But I’m writing less for speculators than for cautious lawyer-investors � those who spend long hours in a legal practice, who don’t have the time or inclination to try to outsmart the professional stock pickers, and who mostly want a prudent way to safeguard legal earnings for the future. For these investors the goal is not to lose, either to inflation or market volatility. That’s why understanding potential risk is important. If you think you fall into this latter category of investor, or if the market swings in the past two months have made you more aware of your potential to lose money, this summer might be a good time to make sure that your investments are allocated to handle the considerable market risk that always exists. THAT WAS THEN � THIS IS NOW Perhaps the easiest way people evaluate risk is to look at the historical returns for an investment. If a mutual fund has risen for the past few years, it seems a safe money-making device. If the returns are good for the past 10 years, it seems an even surer bet. Unfortunately, this measure of risk can prove horribly misleading. Funds or asset classes often post the best series of returns just before everything falls apart. Just look at the run-up in the Nasdaq at the turn of the century and the subsequent loss of almost half its value between March 2000 and March 2001. The common warning “Past performance is no guarantee of future results” ought to be pondered as closely as the string of immediate returns. And what holds true for individual stocks or mutual funds can hold true for entire national economies. Remember the 1980s, when Japan appeared to be the economy of the future? It’s been a long way down for Japan’s Nikkei since 1990, and that stock market is still far below previous highs. We have no good reason to believe that the United States is somehow immune from the same kinds of risks. Our capitalistic economy has had a great economic run over the past 130 years or so, moving from what in some ways was an emerging market to a position of global dominance. It was wonderful that America got so rich and didn’t wind up like Argentina or Russia. But the very extent of the U.S. stock-market success creates questions about whether comparable high returns are likely in our future. How lucky can one country be? Americans shouldn’t count on twice winning the economic lottery of nations. Granted, the historical record of U.S. stock returns is enticing; it makes for an impressive chart demonstrating the reward of holding stocks for the long run. But remember: The past is over, and there’s no guarantee that the future will show such generous returns. FAT TAILS If the initial inclination of the individual investor is to look to history to evaluate risk, many with more investing knowledge also rely on mathematics. A variety of numerical measures of risk exist, largely derived from the bell-curve graph of symmetrical probabilities (technically known as a Gaussian distribution). Ideally, investors might be able to rest securely in the seemingly scientific answer that most portfolio returns will stay within a standard deviation or two of the average return and radical drops are statistically unlikely. Alas. The comfort from such quasi-scientific numbers is illusory. Our world is not so exact. As the British journalist G.K. Chesterton once noted in a different context, the world “looks just a little more mathematical and regular than it is; its exactitude is obvious; but its inexactitude is hidden; its wildness lies in wait.” In investing, such wildness was apparent on Monday, Oct. 19, 1987. That day, Black Monday, the Dow Jones industrial average fell more than 22 percent. Such a market occurrence was a 22-sigma event, meaning that the chance of it occurring was one in a googol (a one with 100 zeros after it), as the mathematician Benoit Mandelbrot (known for his work on fractal geometry) and the trader Nassim Taleb (whose 2004 book, Fooled by Randomness, is one of the smartest investing books out there) wrote in a Financial Times article. Statistically, that market fluctuation on Black Monday was impossible. And yet, like Galileo’s Earth, the market did so move. In mathematical terms the distribution of stock-market returns has “fat tails.” In other words, statistically unlikely swings appear far more frequently than estimates based on the traditional bell curve would permit, and the ends of the curve (the tails) don’t taper out into practical impossibilities, as they would in a Gaussian distribution. It thus appears that the traditional mathematical evaluations of risk are in some ways even less accurate than the historical record that at least discloses events like Black Monday. So, as Mandelbrot and Taleb warn in a 2005 Fortune article, because these conventional measures of risk severely underestimate potential losses, “your exposure is larger than you think.” DIVERSIFY, DIVERSIFY So how should the busy lawyer handle all this risk exposure? The best answer is to do three things: Select an overall asset allocation to defend against calamity; diversify broadly, including significant international holdings to hedge against domestic downturns; and don’t overlook less common asset classes. • The first step is to decide the basic division between stocks and fixed income. Models based on historical returns might recommend a stock allocation as high as 80 percent for a younger investor, based on the historical risk premium from holding stocks. Yet given the limitations of historical analysis, a more conservative allocation is certainly reasonable. Any investor could do far worse than to follow the advice of finance professor Benjamin Graham in his classic book, The Intelligent Investor. Graham suggests a “fundamental guiding rule” of having at least 25 percent but no more than 75 percent of your portfolio in stocks. He advises that “the standard division should be an equal one, or 50-50, between the two major investment mediums” of stocks and bonds. • A second step is to ensure that those investments are broadly diversified. In particular, stock investments ought to be widely distributed among the U.S. and international markets. Domestically, you can pick index funds, which offer exposure to entire market segments and thus remove the (significant) selection risk that you or your mutual-fund manager picks stocks that prove unable to outperform the market. Remember too not to confine your portfolio to the United States. It’s not uncommon for investors to buy far more of the stocks of their native country, a tendency that finance academics call the “home bias” puzzle. For example, many U.S. investors will devote less than 12 percent of their equity portfolio to international stocks. A far higher percentage of international holdings is likely justified. Over the past 30 years or so, an equity allocation of about 30 percent to 40 percent in international stocks would have provided the best results in terms of increasing returns while lowering risk. And, of course, in interpreting this data, remember that it includes one of the largest bull markets in U.S. history, during the 1980s and 1990s. We are unlikely to see such great returns again in the immediate future, so an even higher international allocation might be justified to diversify away more of the country risk of a U.S.-dominated portfolio. In fact, it wouldn’t be at all unreasonable to split your stock allocation evenly between domestic and international companies. • A third step is to achieve even greater diversification by branching out into some less common asset classes. It’s both easy and sensible to buy index funds of the total U.S. stock market and the developed foreign nations. By itself, this would provide a substantial amount of investment diversity to reduce risk. Yet even greater diversification is possible than that obtained by only the familiar indexes. For example, a fixed-income allocation can now easily include international debt and inflation-indexed bonds, so investors can branch out beyond traditional Treasury bonds and money-market funds. And outside of fixed income, exchange-traded funds (which typically replicate a market index like an index mutual fund but trade like stocks) now permit exposure not only to a wide range of specialized stock indexes but also to commodities such as gold and oil. Investment costs even with ETFs are still something to minimize, of course, but overall, individual investors are gaining an increased ability to obtain the range of diversification previously available chiefly to large institutions. So allocate cautiously, and diversify broadly. The market’s wildness lies in wait.
Robert L. Rogers, associate opinion editor of Legal Times , writes the Legal Tender column on personal finance. E-mail questions, comments, or suggestions for future columns.

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