RISKS and SIMILAR STUFF ABOUT INVESTING

INVESTORS ARE NOT NECESSARILY RISK ADVERSE AS MUCH AS THEY ARE LOSS ADVERSE

While the glossary contains definitions on numerous issues of investing, the elements of risk need more definitive commentary- mainly because this is the key area where almost all investors have problems. There is a unique risk element with 401(k) participants however. First is the fact that far too many 401(k) investors take too little risk by using Guaranteed Investment Contracts (GIC')s and other low yielding investments. Second, there is a relatively large number of employees that take too much risk- but the wrong risk. That's because employees are also putting too much money into their own company's stock- in other words a heavy reliance on one stock that, if it drops precipitously, can decimate the overall return. (See real life story under Dollar Costs Averaging). A 1995 New York Times article noted that 60% of Texaco employees' money went either into money market funds or Texaco stock. At Xerox, 60% of employees money was invested in bonds. At Public Service Electric and Gas Company, 70% was in GIC's.

Employees, for the most part, should focus on a diversified equity portfolio for long term reward (with caveats) since equity returns have outdistanced both GIC's or bond investments. But a Peat Marwick study of plan participants indicated that only 36% had chosen stocks as having the best return over the last 30 years. More than 40% had actually chosen fixed income investments. The chart below does show things are getting better, but employees- and employers- have a long way to go to properly understanding investments risks and rewards.

Fund Type	1989	1991	1993
Equity	9%	11%	16%
Company Stock	29	25	24
Bond	5	5	7
Balanced	11	13	13
GIC	32	31	27
Money Market	9	9	7
Other	5	6	6
Total Equity Investments	44.6	43.8	47.9
Total Equity Excluding Company Stock	15.6	18.8	23.8

The risks of ignorance are enormous. Look at the situations below and for the various rates of return selected.

A study by Ibbotson in 1994 indicated that since 1925, the stock market has returned an average annual 10.3% return (dividends reinvested); intermediate bonds averaged 5.2%, T-bills averaged 3.7% and inflation 3.2%. I chose to be a little conservative with stocks and brought the overall return down to 10% (most studies show the market's return over the past 10 years as being well over 11%), but was a little more aggressive with bond returns moving them up to 6.5 % and cash to 4% (taking into account some GIC's). Remember these are historic averages- projecting more than this is not realistic. Check out what the late 60's and 70's did. See section on returns.

FUTURE VALUE OF 401(K) PLAN (tax deferred account)

	4% CASH	6.5% BOND	10% STOCK
$25,000 IN 10 YEARS	$37,000	$47,000	$65,000
$400 PER MONTH IN 10 YEARS	$59,000	$68,000	$82,600
TOTAL	$96,000	$115,000	$147,600
		+ $19,000 over cash	+$51,600 over cash
			+ $32,600 over bonds
$25,000 IN 25 YEARS	$67,000	$120,000	$271,000
$400 PER MONTH IN 25 YEARS	$206,000	$301,000	$535,000
TOTAL	$273,000	$421,000	$806,000
		+$148,000 over cash	+$533,000 over cash
			+$385,000 over bonds

The intent of this chart is not to suggest that you put all your eggs in one basket and simply pick stocks in total. Almost everyone should use some bonds and possibly cash- though normally in smaller increments. But as a reference point, it's tough to dismiss the fact that stocks outproduced cash by almost $400,000 over 25 years. That's a lot of extra retirement comfort.

Assume for our next examples, I had two different allocations: A. 50% stocks, 25% bonds and 25% cash and B. 50% stocks and 50% bonds.

FUTURE VALUE OF 401(K) ASSET ALLOCATION PLAN

	4% Cash (25%)	6.5% Bond (25%)	10% Stock (50%)
Total in 10 years	$24,000	$28,750	$73,800
Total plan $126,550
Total Plan in 25 years	$68,250	$105,250	$403,000
Total Value $576,500

	4% Cash (0%)	6.5% Bond (50%)	10% Stock (50%)
Total Plan in 10 years		$57,500	$73,800
Total Plan $131,300

Total Plan in 25 years		$210,500.	$403,000
Total Plan $613,500

Of course there are all sorts of variations that one might use. It depends on economic conditions, amount of money required at retirement, age, and certainly the number of selections. Just pick something that is relatively close for the condition that exists and then adjust as necessary when things change. You are not married to any specific breakdown at all. Vary as necessary. That's why rebalancing is of such importance.

However, before you invest, you've got to know the risks. Investing is not as easy or risk free as some of the magazines would lead you to believe. Most of these texts or articles rarely address many of the terms and statistical evidence used in the industry by professionals. I am not saying that you have to understand all of these theoretical concepts, but you at least have to be aware of the basics so that you can include the commentary in your own analysis or simply dismiss them altogether. But it's not just me. Most recently, the likes of Money Magazine, Kiplinger's, Worth, etc., have included these issues. Further, when the SEC requested consumer commentary on how to make the risks in mutual fund prospectuses more definitive, it suggested that the Treynor measure, Sharpe ratio and others might be included. Better you read about it here from me rather than hear something later about your fund or investment and you don't have a clue.

I have selected certain items, because of my extensive teaching, that absolutely is a NEED TO KNOW since, unless you have a reasonable understanding of diversification, beta, correlation and a few other "necessary" definitions, sooner or later you'll commit investment suicide. What you don't spend time on now will haunt your retirement lifestyle and lifetime later on.

The essential definitions are as follows. You may find minor variations from text to text, but the basics should hold.

But, as always, I'll add this caveat. Reading unquestionably will make you a better investor, but if you do not know how to use the HP12C, you will find it difficult- if not impossible- to apply the principles properly.  

Financial Risk: This involves leverage or debt. The greater the amount of a firm's assets are financed by debt, the greater the probability of insolvency or bankruptcy and the inability to pay interest and principal when due-though debt ratios vary widely from industry to industry. The risk to investors is, in part, mitigated by higher coupon interest and possible purchase prices at discounts to par.

A more general statement is simply the risk of a company in the being able to perform to all the provisions and expectations in issues of debt and equity securities.

Default Risk: Similar to financial risk, it involves the probability by a debt issuer to meet interest and/or principal payments, i.e., the problem that a corporation or municipality will default on its principal or interest repayments in the future. The longer the term to repayment of principal (maturity), the greater the risk. A general gauge to this risk are the ratings from the major bond rating services such as A.M. Best, S&P, Moody's, Duff's and Phelp and others. The higher the rating, everything else being equal, the less the risk of default- though the rating services have had some problems identifying financial problems quickly enough and notifying investors before something really went wrong.

Business risk: This risk in inherent in the operations of the firm and/or industry. Some of the issues for review of a business's operations would include:

1. Is the business sound, well established and stable or new and untested?

2. Is it a cyclical company, depending on surges of business at certain times of the year?

3. Is the volume of business expanding, contracting or stationary?

4. Is the plant modern and up to date or in need of substantial overhaul?

What about sales techniques and advertising?

5. Is the reputation strong within the industry?

6. Is there strong, anticipated or negligible competition?

7. What is the ratio of profits to invested capital for various periods of time?

DURATION: Represents the price volatility of a fixed income security- a bond for example. It is the weighted average term to maturity of the bond's cash flow. It is a better measure of a bond's sensitivity to interest rate changes than maturity because it takes into account the time value of cash flows generated over the (proposed) life of the bond. Future interest and principal payments are discounted to reflect their current value (remember the HP12C) and then multiplied by the number of years they will be received to produce a value that is expressed in years- duration.

Say what? An example might help. Assume you owned bond A with 10 years to maturity and it paid 8%. You also owned bond B with a 10 year maturity paying 10%. With which bond will you get back more money faster? B, obviously, since it will pay off the $1,000 par value sooner and it has a shorter duration. How about Bond A with a 10 year maturity and a yield of 8% and bond B with 8 years to maturity paying 6%. Now which one is better? Now it's not so easy because in bond A you certainly get back a higher interest rate per year but the $1,000 is not due till 10 years. With bond B, you get less money per year but get the $1,000 two years earlier. There's a few formulas that can show you and the HP12C will give you the correct answer, but the overall issue is this. The shorter the duration on a bond or bond fund, everything else being equal (like ratings for example), the better. The higher the yield, the shorter the duration.. The shorter the maturity date, the shorter the duration. It is a much better measure than average maturity and can take into account call features of a bond and sinking fund payments. Duration may be computed for bond funds and, similar to time to maturity, can be used to estimate the effect of interest rates on a bond fund's share price. Some funds now compute this but it is seldom asked for by investors. So why all this commentary? Because more funds are providing this number to investors and even some of the basic financial magazine comment on it. So does the SEC since they believe it might be one of the major risk determinants that should be provided to bond investors. If duration is not provided or it's too hard to follow, ask for average weighted maturity and current yield of bond fund. Then compare info of one fund to another fund.

Interest Rate: Also called money rate, capital value and income risk. If you own almost any bond or bond fund, then you must understand that your principal will go up or down as interest rates in the economy go up or down. Look at the visual display and line A below. Assume that today you bought a $1,000 bond that earned 8% per year. You'd get $80 per year, paid $40 every six months.. Now let's assume that five years go by and interest rates in the economy have gone down to 5%- line B. Anyone buying a bond at that time would get only a 5% return. But you hold a bond paying 8%. So the simple question is, "would an investor pay you pay more or less for your bond paying 8% than a bond paying 5%? More, quite obviously, and therefore the 8% bond you hold you pay might go up to a PREMIUM of, say, $1,200- line c (figures will vary but the essence is valid). If you owned a bond fund under that example, your return would consist of the money earned on the bond(s) each year plus any increase or appreciation in principal.

NO CHART PROVIDED

Let's take the opposite tack with line D and assume that interest rates had actually gone up- say to 12%. A person buying a new bond then would get 12%. The question is therefore, would someone pay more or less for your bond only earning 8%. Less, quite obviously, and your value would drop to a DISCOUNT (line E)- say $800, line E. Therefore, in times of increasing interest rates, you'd still get your interest each year but the value of your principal could go down and down- possibly more than offsetting any returns from the interest. 1994 was a good example of increasing interest rates and falling bond values.


Also as a general guide, longer term bonds are more greatly effected in price than shorter term bonds. The chart below clearly indicates that.

Percent Change in the Price of a Par ($1,000) Bond paying 8.5%

Stated Maturity 2% rise in rates 2% decrease in rates

-----------------------------------------------------------------------------------------------------------------

Short term (2.5 years) -4% +5%

Intermediate term (10 years) -12% +15%

Long Term (20 years) -17% +22%

So how does some of this play in the real world? We've already talked about the most recent past in 1994, but check out the rates from the early 80's up to the beginning of 1994. Overall, interest rates were going down and down and down. To determine how well you might have done, consider an example in the ownership of long term bonds and rates went down 1% per year. How much of appreciation might have been possible? (Use the chart above for 20 year bonds).

USE CHARTS FROM FEDERAL RESERVE BOARD

If I just simply say that you'd get half of the 22% change in price for a 20 year bond (only a 1% change in rates), then you would have picked up an 11% return PLUS whatever the yield on the bond that year (we'll say 6%) for a total annual return of 17%. That's a pretty impressive return for a risk factor that some consider to be half that of stocks during much of that period. Admittedly, one would probably not put all their money into 20 year maturity bonds- equities and intermediate bonds also did well.

So, did investors pay attention and use a lot of bonds or bond funds during this time frame? No, since many did not comprehend either what Greenspan was doing or the effect on fixed income investment. Some finally did see the benefit, but only late in the game and started to use some bonds during 1993. Well, 1993 was not so bad for bonds since rates kept coming down in the early part of the year. But, as we all found out, 1994 had the greatest increase in interest rates in 50 years. So bonds and bond funds took a bath. Many people lost mucho dollars. It's the old story, buy high and sell low. But now that you understand the graphs and charts above, you'll never make that mistake, will you? Nor will your children.

Bond Maturity Coupon Price of a $1,000 Bond if Interest Rates for Treasury instruments as of 10/94.

	Increase 1%	Increase 1%	Decrease 2%	Decrease 2%
1 Year 6.15% coupon	$991	981	1,010	1,019
5 Year 7.48% coupon	960	922	1,042	1,086
10 Year 7.80% coupon	934	874	1,072	1,150
30 Year 7.97% coupon	897	810	1,125	1,278

GNMA Risk: Normally Government National Mortgage Association Passthrough securities are considered among the safest investments possible since they are backed in full by the U.S. Government. However, only the principal itself is guaranteed against default- not the interest payments nor, most importantly, the value of the securities in the secondary market. As such, the returns can suffer far more than "ordinary" bonds and cause a lot more risk to the portfolio than what is normally recognized.

Background: Lenders on residential homes usually have to follow very stringent credit guidelines for the borrowers. But if the borrowers qualify, the lenders may then able to take these loans and sell them to the Government National Mortgage Association which packages them in $25,000 blocks and sells them directly back to individual investors. They normally contain a number of fixed rates mortgages all paying the same rate. There are mutual funds that buy millions of dollars of various yielding GNMA's and sell pieces to investors. GNMA mortgages do not normally mature in 30 years. Because of refinancing, people moving, etc. they tend to mature at different times and this is called FHA speed. (Depending on economics and interest rate volatility, it's somewhere around 8- 12 years.)

At first glance, it might appear that if rates went down, GNMA values would increase the same as "regular" bonds. But homeowners are aware of refinancing opportunities that might become available when rates drop. GNMA's therefore can experience a LOT of refinancing when rates drop. Investors therefore get their money returned as rates are going DOWN and then have to find something else that paid as good. It's probably not going to happen at the same risk level (see risk of reinvestment). It's absolutely not what the investors wanted. So, GNMA investments may tend to go down in value when interest rates go down- or at least will not appreciate in the normal bond fashion.

On the other hand, if interest rates were to rise, the FHA speed increases- in other words fewer and fewer people refinance or move because they would only meet with higher interest rates on the newer home. Instead of possibly being paid off in 10+ years under normal conditions or FHA speed, the time frame increases. A GNMA becomes a lower paying longer maturity bond when rates increase. That's normally not advantageous.

What have the annualized returns been over the past few years when compared to a high yield fund or long term bond? I have used some Vanguard bond returns (source Micropal) - expenses are low and they're clean- no derivatives messing up the returns. 10/94.

Time Frame GNMA Long Term Corporate High Yield

Time Frame	GNMA	Long Term Corporate	High Yield
1 Year	11.34%	15.14%	13.82%
3 Years	6.02%	8.78%	10.27%
5 Years	9.18%	12.38%	13.11%
10 Years	9.45%	10.77%	10.53%

The five and three years periods are more reflective of current economics and probably should be given more weight. And there certainly is a difference. If you had $25,000 five years ago invested in each, the GNMA would now be worth (compounded annually) rounded $38,800; the Long Term Corporate $44,800 and the High Yield, $46,300. Some say the high yield bonds have more risk. Yes, they do. But I say that in a moving interest rate climate, it's tough to figure out which way a GNMA will go since there are so many variables. So I say that is risky in itself.

Bottom line- in relatively stable interest rates climates, GNMA's are fine and pay a slightly higher interest rates than other government obligations. You also have no problem with default on the principal. But if the interest rate climate is volatile, GNMA's are no longer the "safe widow's or retirement investment" since you just don't know what they may do. And considering what some GNMA managers do by hedging with derivatives to offset interest rate movements- or by trying to increase yields, these can really be difficult to understand. CAVEAT EMPTOR. I don't think their worth the effort in most cases.

Bond Ratings Risk

The higher the rating, the lower the risk of default- both to principal and interest payments.

Moody's	S&P	Fitch	Duffs & Phelps
Aaa	AAA	AAA	AAA
Aa1	AA+	AA+	AA+
Aa2	AA	AA	AA
Aa3	AA-	AA-	AA-
A1	A+	A+	A+
A2	A	A	A
A3	A-	A-	A-
Baa1	BBB+	BBB+	BBB+
Baa2	BBB	BBB	BBB

Ratings above BBB are called investment grade

Ratings below investment grade are called junk bonds. However, as you can hopefully recognize, they are not all close to default (D).

You should ALWAYS check on the average ratings of your bond funds.

Baa3	BBB-	BBB-	BBB-
Ba1	BB+	BB+	BB+
Ba2	BB	BB	BB
Ba3	BB-	BB-	BB-
	CCC+
Caa	CCC	CCC	CCC
	CCC-
Ca	CC	CC
C	C	C
	C1
		DDD
		DD
	D	D

If a bond's rating is reduced, the price of the bond will tend to fall all other things being equal. The reverse is also true and is a way some bond funds make extra money- particularly noticeable in "junk bonds" in an improving economy. A fund manager who buys lower rated bonds- say CCC average- and expects the economy and/or the prospects of the company to improve may well have the bonds re-rated upwards by a major service. So since the rating has increased, so do the prices. This same scenario exists for municipal bonds.

Dollar Cost Averaging: (DCA) In most textbooks, dollar cost average is considered a low risk "no brainer" way of investing. But it can be a very risky venture leading to a lot of bad investments and lost money.

First, the basics. DCA means putting in the same amount of money each month regardless of market volatility. In doing so, an investor is unconcerned about the swings of the stock (or fund) and doesn't have to try and find a low price on which to buy. The price of the shares average out over time and can still produce an acceptable profit- assuming that the ending value of the shares is higher than the dollar cost average- not an absolute guarantee.

For the example, assume you put in $100 per month into Fund X:

Month	Amount Invested	Share Price	Number Purchased
1	$100	$50	2
2	100	75	1.33
3	100	100	1
4	100	66.66	1.5
5	100	40	2.5
6	100	25	4
7	100	33.33	3
8	100	66.66	1.5
9	100	80	1.25
10	100	80	1.25

Total $1,000 19.41 Shares

Dollar cost Average = How much the shares cost divided by how many shares purchased = $1,000/19.41= $51.52.

Admittedly, I made the stock very volatile to make a point. But as you can see, while you would have preferred to buy all the shares at $25, you just as easily might have purchased them at $80 or $100. DCA avoids the "problem" in selecting the best time to buy. It is an absolutely normal way of investing when one is using 401(k) investments and other investments- even IRA's- where you are investing money each month.

But there are problems. First the standard method of investing money under DCA doesn't necessarily produce the best returns. Another method called Value Dollar Cost Averaging requires an investor to buy or sell mutual fund shares so that the portfolio grows by a set amount each month or quarter. Suppose you invested $1,000 in Fund A and you wanted the fund to grow by $100 each month. If in the first month the account grew to $1,025, you would deposit $75 (now it's $1,100). If in the second month the account grew to $1,290, you would sell $90 (now it's $1,200). Supposedly in the past, this has shown returns 24% over normal dollar cost averaging. There are other methods that state increased returns versus the regular DCA. This is not the main issue.

If you have money to invest as a lump sum, DCA produces a LOWER return than investing the money all at once. Two researchers (Williams and Bacon) have discounted dollar cost averaging by statistically showing that putting all the funds in at one time outproduces dollar cost averaging by two to one. They invested a theoretical sum in 90 day T-bills and moved into the S&P 500 over a years' period. They compared these results with investing all the funds at once- starting with different periods from 1926 to 1991.

"Nearly two thirds of the time, a lump sum strategy significantly outperformed dollar cost averaging". The lump sum approach returned an annualized return of about 12.75% while the dollar cost averaging was just 8.50%. Reducing the dollar cost averaging from once a month to three or four times per year also increased the return. This study should not be all that surprising. First, stocks have outperformed money market and bond funds over almost all time frames (and certainly beyond 10 years). Also, with interest rates being so low in many time frames (as they are today), its tough to get an decent annual return with the bulk of funds sitting in 3% bank accounts. Admittedly, many people don't like to dump everything they own into the market all at once and like to test the market, so the actual use may be debatable. But most money managers get paid to produce results and a two to one play is awful good odds.

Here are some numbers to put the study into perspective. Assuming $25,000 was invested in 1980 and assuming the study showed returns over 15 years to 1995 matched those of 1926 to 1991, the lump sum investing would have grown to $151,247 versus the DCA value of $84,993 (annual compounding). That's over $66,000 more using lump sum investing. O.K., you say, the assumptions may not be valid and have changed downward. Fine, we'll accept that statement. So we'll say the difference is not $66,000, but $50,000. Or even half to $33,000. Regardless, investors need to recognize the study and its implications before they can dismiss the numbers.

Thirdly, and perhaps most importantly, many investors using DCA don't bother to watch the investments after they start. They may not rebalance the investments- normally a once per year revision. While true that over time stocks outproduce other investments, you have to pay attention since the managers may have changed, the fund may have changed identity and, most importantly, the economics might have changed. For example, you don't want to end up in another 1970's marketplace where stocks did absolutely terrible for some time- about 50% in 1973-1974. Sure, stocks finally caught back up and outproduced other investments after that, but there is no person that can tell me they could stomach a 40%+ loss without having sleepless nights (even 20%+). That's the absurdity with many magazines saying, "don't worry, just ride it out. It will come back". Well, what happens if the market still sucks when you need money for your kids education- or some medical emergency? The point is

INVESTORS ARE NOT NECESSARILY RISK AVERSE AS MUCH AS THEY ARE LOSS AVERSE

and my attempt here is to help you use the market for as much return as is feasible without getting caught in major downside losses.

Here's a real life story that addresses two problems at once- no continued involvement in the investment process and the use of a single stock for much of the portfolio. My sister's husband worked at Digital for many years. They bought Digital stock frequently at special Digital prices, dollar cost averaging all the time. The stock went from below $20 a share up to a peak of $200. Unfortunately, no one paid any attention when it went up (except to note how much money they "made")- and they didn't pay any attention when it went down and down and down- well, you get the point. George died of a massive heart attack several years ago. I had to value the stock at the date of death- it was $54.00 per share. (Value Line rating service rated it a D at that point.) That's almost a 75% drop. It went further down from there- $16.00 a share though it went up somewhat later on. Mary was "out" over $80,000 because no one paid any attention to the economy or the potential (or lack thereof) of the company. Past research shows that company that goes that far down will NOT reach its previous peak. Digital will probably never get back to the old glory days- at least not in Mary's lifetime. IBM- has come back with a vengeance- but I submit that is an anomaly.

Admittedly I used a single stock for the portfolio. But this is NOT an isolated incidence. Many employees load up on their employer's stock. Ownership of just one stock (see unsystematic risk) that comprises almost all of the family's fortunes purchased through "no brainer" dollar cost averaging can be fraught with risk due to the "ease" of investing and the lack of monitoring of the investment. It is unfortunate that the magazine articles do not reflect the real world reality of what actually happens.

If an investor uses a diversified portfolio, it is debatable that the losses ever would have been that severe. But I may once again see the terrible investment environment of the 70's, so it pays to be vigilant.

Dollar Cost Averaging is no excuse for not doing research, monitoring and rebalancing.

YOU CANNOT AFFORD TO BE NEGLIGENT.

Yield Curve This curve is for normal economic conditions where longer term bonds earn more than short term bonds- simply because there is more uncertainty in longer periods. However, the curve flattens considerably at about five+ years, so one takes a lot more risk with long term bonds than with intermediate term bonds. It's therefore a good reason to have an intermediate bond fund in a portfolio- preferably with low expenses.

NO CURVE

Of course there are times when short term rates are higher than long term rates usually when one is experiencing high inflation and the FED is raising short term rates interest rates in an attempt to slow the economy. Investors believe that inflation will finally abate and that long term rates will be more "reasonable". In such cases the yield curve is "reversed".

This reverse curve doesn't happen frequently, but everything with economics affects what will happen with your investments so it pays stay alert and READ.

Callable Risk: Also known as prepayment risk. A major issue for most bond investors since at least the mid 1980's. It is the right of a corporation or municipality (even the U.S. Government on a few issues) to call the bond due and payable- to pay off the principal prior to the stated final maturity of the bond. The corporations and municipalities would call a bond due to an overall reduction of interest rates in the economy.

Let's use this example. Assume a municipality had issued a bond in 1985 at 9%. If they issued $100,000,000 in total in bonds, that's a lot of interest to pay. And it looks even greater if interest rates had dropped since then- we'll say they went down to a current 6%. The municipality would prefer paying just 6% and may be able to do that if the bond was originally "callable". (Most bonds are issued this way but you may have to check or ask your broker about your investments.) In such cases the entity can call the old bonds due and pay you back $1,000 for each of your bonds much earlier than you perhaps had anticipated or liked. The problem is that while you did get your money back, your opportunity to find another bond of similar rating earning 9% is probably nil.

Many bonds have a form of call protection where they may not be called for a certain number of years. Such bonds may also pay a premium if and when called- though such premium may be small. This risk is tied directly to Risk of Reinvestment below.

Risk of Reinvestment: This risk relates primarily to the return of interest, dividends and/or principal on your investment prior to "normal" maturity- such as callable bonds- or due to regular repayments of principal- such as on a mortgage or GNMA. The major problem occurs when economic interest rates are falling and monies received must be reinvested in a lower yielding economy. Or in order to achieve the same return on new monies, investors must take on additional risk.

As an example, look again at the example above. You once earned 9% but then you got your $1,000 back and were able to reinvest only at 6%- assuming the same risk of the prior investment. If you did find another investment earning 9%, it invariably was at a much higher risk.

Inflationary risk: Synonymous with the movement of the CPI (Consumer Price Index), it represents the real (or, at times, the perceived) movement of the supply and demand curve. Put another way, if the supply of a product that people want goes down, or the demand goes up, or both, prices tend to go up- hence positive inflation. If the factors are extreme, the FED considers raising the interest rates in order to slowdown the economy and finally halt the high inflation. 1994 is a prime example and how the FED raised rates to stop the projected inflation that was to occur late in 1994 and in 1995. While the FED has entertained a thought about zero inflation, most economists feel that inflation will continue- albeit slowly for the time being, maybe around 3.5% to 4%. Nonetheless, over time, the MONEY YOU GET IN THE FUTURE IS GOING TO BE WORTH LESS. For example, having $100,000 now and burying it in the back yard while inflation is 4% means that real value in five years is only $82,000 in today's dollars. In 25 years that $100,000 is worth just $37,500. (For those of you more technically inclined, 4% was used as an annual compounded discount factor). Even if you do invest, if you don't get a return at least equal to inflation, then you are still going to go further behind each year. The greatest problem exists in fixed income investments- government bonds, savings deposits, fixed annuities, etc. If you wish to stay ahead of inflation- which is almost mandatory unless you have LOTS and LOTS of money, you invariably need to look at the higher, though usually more volatile, returns historically available from stocks and other growth vehicles. This is how inflation has looked for the past few years.

INFLATION

1982	3.9	1988	4.4
1983	3.8	1989	4.65
1984	4.0	1990	6.1
1985	3.8	1991	4.4
1986	1.1	1992	2.9
1987	4.4	1993	2.7
1988	4.4

Actually, the low inflation rate of around 3% is pretty good and usually bodes good for the marketplace. Why do I say "low?" Look at the rates from 1973 to 1981

1973 8,8%

1974 12.2%

1975 7.0%

1976 4.8%

1977 6.8%

1978 9.0%

1980 12.4%

1981 8.9%

As another problem, remember that even if you did get a "great" return on a conservative investment- we'll even say a money market fund at 5%, you still must account for taxes (assuming a non tax sheltered account). If you were in the 25% average tax bracket, your return ends up being just 3.75%. And 3.75% is not going to take you anywhere.

Foreign Exchange and Expropriation Risk: The movement of the dollar against foreign currencies directly affects the value of foreign securities. For example, a rise in the dollar as compared to the foreign currency- or a drop in the value of the foreign currency- means that the foreign security will be worth less more in value to the U.S. owner since the conversion to US currency will result in less dollars received. On the other hand, a drop in the dollars value as compared to the foreign country's currency (the dollar has been dropping against most foreign currencies for years) means that the value of a foreign security has gone up since more US dollars will be received upon conversion. Many investors seem oblivious of the risk of conversion as was evidenced by the vast sums invested into foreign bond funds in early 1991 while the dollar was significantly appreciating. By the same token, much money had been placed in Mexico before the melt down of the government and the peso in 1994. The risk is the greatest with bonds since they have, by nature, a fixed return. Even with changing interest rates, it's debatable how much appreciation may be generated on a bond when interest rates are already so low and expected to stay that way at least for the foreseeable future. Even higher yields on foreign bonds may be negated if the foreign currency appreciates or the dollar depreciates. Many experts say that the best overseas investments are equities since they have the opportunity to appreciate enough to offset any exchange movements.

DOLLAR GRAPH

It is also worthwhile to note that studies have indicated that there is no consistency to determining when or if a currency fluctuation may take place in any particular country. So even if a fund manager may want to hedge currency exchange risk, it's difficult to know whether it is a worthwhile endeavor worth the cost or just a waste of time and money.

Diversification: A more definitive definition is addressed under unsystematic risk, but there needs to be a clarification of terms. Diversification- as identified under correlation and systematic and unsystematic risk- means having at least 10- 15 negative or randomly correlated stocks or bonds in a portfolio in order to negate the effects of unsystematic risk.

Diversification also means not putting all your eggs in one basket. That is, having some investments in stock, some in bonds, some in real estate, etc. But that is better known, and is called more correctly as asset allocation in this text.

Diversification is also defined in a prospectus by something that's just plain confusing and is a requirement of law. You at least need to hear of it. If a mutual fund is diversified, it means that "at least 75% of the assets are invested so that no more than 5% of the stock is invested in any one company nor that the fund owns more than 10% of a company's outstanding stock". In "real life" terms, it says that a fund can't load up too much in any one company. A non diversified fund is allowed, under the contract, to load up more in a singular area- hence is probably more risky. However, pursuant to the first definition, above, almost all mutual funds are diversified in that they own more than 10 -15 stocks.

Risk of War and International Tension: Most noted by the Iraqi war where, irrespective of the huge glut of oil, prices rose dramatically due to the threat of conflict. Once the tension eased, prices dropped to pre-war levels- in some cases even lower. Investors swayed by emotionalism lost billions of dollars on oil scams. The wars in Somalia, Haiti, and Bosnia had little, if any, impact however.

Psychological Risk: This is a social risk. It is the risk that the investor will act emotionally instead of logically in reflecting on current waves of great optimism or pessimism that periodically sweeps the investment market, or on current moods to certain stock groups (small cap or technology for instance) or individual stocks. There will be little change in this disposition in the future. As long as people don't do much research and investing, many will still tend to buy high and sell low. Many stocks and other investments will be purchased through the cocktail party enthusiasm prevalent at every social function.

I are not saying I am prefect in our investment analysis and that I have never made a mistake, but good research definitely helps one avoid the major mistakes. Playing the market on whims and fancy just doesn't cut it.

Liquidity Risk: Though used interchangeably with marketability, it's not necessarily correct. It is best described as the ability to convert an asset to cash. The difference is easily noted in hard assets or thinly traded securities. As an example, take the Hope Diamond. It's value may be $5,000,000, but if one needed to liquidate in an hour for cash, the price would undoubtedly be much, much less. In order to get full value, it would need to be shopped to several buyers- taking perhaps several weeks or months. The point being is that almost anything is liquid- but the issue is what the price needs to be in order to accommodate such liquidity. The same scenario exists with thinly traded stocks and bonds- those that don't sell that often and where there is little daily demand. If, for example, a fund manager of high yield bonds or small cap stocks has a"run on the bank" and needs to get cash fast, will almost invariably have to discount thinly traded assets in order to pay investors.

Marketability: This is the ability to sell an investment at its "appraised value". For example, if a stock is valued at $50 on the New York Stock Exchange, it probably can be sold immediately at a price very close to $50.00. It's liquid AND marketable. However, the case is not true for illiquid investments such as thinly traded stock and bonds and other assets such as real estate. As an example assume the market value of, say, a piece of real estate is $500,000 IF IT HAS A NORMAL SELLING PERIOD OF SIX MONTHS. It's marketable in the "normal" selling time period- but definitely not liquid. A stock on the New York Stock Exchange, however, is both liquid and marketable since it can be sold, effectively, at it's current value in just a few minutes. Hard assets rarely have the marketplace to sell quickly.

Many investors think bonds are both liquid and marketable. A misconception. Many bonds, particularly in small amounts, are normally discounted if a fast sale is required. Some of these discounts are quite substantial. CAVEAT EMPTOR.

Systematic Risk: The movement of a security caused by the change of the market as a whole. Also called market risk. Cannot be eliminated by adding more securities. Depending on correlation (described below), one needs to have from 13 to 50 stocks in a portfolio in order to be as diversified as the S&P 500. If just one or two stocks makes up a portfolio, the risk can be 50% grater or more than the marketplace. Further, there is no additional reward that the market gives for taking the greater risk. See graph below.

Unsystematic Risk: The risk of change unique to the particular company (labor strike, equipment failure, sluggish demand, etc.). May be limited or eliminated by proper diversification which is defined as the addition of randomly or negatively correlated securities- about 10 - 15 issues (some texts suggest 20 to 100 but clearly depends on correlation described later). The additional 50%+ risk of owning an individual securities- the unsystematic risk- can be eliminated. The marketplace offers no additional return for the higher risk.

The risk is therefore acknowledged in many 401(k) plans using employer's stock. Though few employees would put all money there, having large portions of a single stock in a retirement portfolio is illogical and increases risk unnecessarily. For the same reasons, it is illogical for most people to own few numbers of individual stocks unless they have had adequate warning of this higher risk. Several years ago the New York Stock Exchange did a study and found that investors held an average of only four stock. Though the overall risk has been somewhat mitigated by the addition of mutual funds to many portfolios, it does show the ignorance of many investors- of the sales capabilities of brokers. CAVEAT EMPTOR

GRAPH

It is also worthy to note that one can have diversified investment

Governmental and Political Risk: Though the President and Congress do not have direct "control" of the Federal Reserve Board, they can- and do- change tax laws. The most recent major change occurred in 1986 where interest deductions were eliminated and depreciation schedules were so lengthened that real estate was put in a tailspin from which it is only recently recovering.

While the FED- with Chairman Alan Greenspan at the helm- do not change tax laws, they do review the economy and adjust interest rates and the money supply in an attempt to fine tune the market. The most recent adjustment was in 1994 with numerous interest rate increases in an attempt to stave off inflation. But the turmoil it caused in the investment community was considerable dropping bond values extensively. With inflation remaining low, we may not see too much volatility in rates for awhile. That said, the budget deficit, social security and significant costs for Medicare still loom over us. Admittedly the most recent economic conditions may, in fact, balance the budget. Unfortunately, many of the spending programs by Congress were not eliminated and could haunt us when (not IF) the economy changes.

RISK OF LOSS: Though rarely commented upon, recent studies show that investors are not necessarily risk adverse as much as they are loss adverse.

Beta- There are many definitions of risk and volatility but the most basic one that is shown in most reports is called beta. It is best shown by the graph below. The graph is not technically perfect but is used in a form that quickly gets the point across. Look at line A. It reflects the movement of an index- we'll say the S&P 500 index since it is the one most commonly used. Whatever this index does, it does by a factor of 1.0 That's also called a beta of 1.0. If you have a fund that shows higher growth than the S&P overall- say 20% more as shown by line B- it will have a beta of 1.2. So, everything else being equal, if the market goes up 10 points in day or week, your fund will go up 1.2 x 10 or 12 points. There is a similar situation that exists when the market goes down- line C. Under those conditions, you fund will drop 20% more- line D.

NO GRAPH

Lastly there is the issue of volatility- how much more or less a fund will vary as the stock market varies. Although again not technically perfect, a beta greater than 1.0 reflects greater volatility both positively and negatively. Everything else being equal, if you want low volatility, you should consider stocks and funds with low betas- under 1.0.

Beta for stocks may be determined by formula or more easily graphed over a period of time comparing them against the S&P average.

CAUTION: Beta should be observed over a long enough period of time to determine the trend of the stock, but not so long ago as to consider radically different economic conditions. Three years- maybe five- is a reasonable time frame, but you might check the last year to see if there is current consistency. If not, do more research. Ten year betas may definitely not reflect current economic conditions.

There are many caveats to betas- some advisors don't like them at all. Check articles and texts for more discussion. However you need to understand beta if you want to dismiss it.

Alpha- This is s statistical review of how your fund was SUPPOSED to do considering its beta and how well it ACTUALLY did. For example, if your fund had a beta of 1.2, then theoretically it would do 120% of the movement of the S&P index. If the S&P did 10%, you would expect 12. But let's say it actually did 16% during that time. It did better than expected by 4%. Therefore the fund could state it had a positive alpha of 4.0 (16- 12).

While different rating services compute alphas differently, the essence is the same- a positive alpha reflects an ability, at least for some time period, that the fund manager was able to pick the best stocks from the group available. A negative alpha indicates that, at least for the time period analyzed and the risk of the stocks selected, the fund manager is not picking stocks very well. Everything else being equal, for the level of risk you are willing to take, a positive alpha is a good sign and a negative alpha is a poor sign. Of course, past history is not reflection of what the fund manager may do in the future, but it is worthy of recognition.

Standard Deviation: Another term used throughout the industry and a new requirement for understanding by investors. It reflects the volatility of an investment per past history and is one of the major tools to compare the riskiness of one investment to another. The graph is the easiest way to understand. I have taken some liberties with the presentation to make it easier to comprehend. The height of the bell shaped curve represents the average return of the investment. As you can see by graph A, it is taller at a 10% return than graph B with a 7% return. But the real issue is the width of the curve. THE WIDER THE CURVE, THE MORE VOLATILITY. THE WIDER THE CURVE, THE GREATER THE RISK. Further, each graphs represents the dispersion around the mean. Say what? More simply, it means how mush the pluses and minuses were for the time frame selected. And the last restriction is that one standard deviation represents the pluses and minuses that could be expected in 68% of the time. Look at graph A and the numbers for stocks over the last 50 years (roughly). The stock market has returned an average of 10% per year but in 68% of the time, the return has been minus 20% and plus 20%. That means that you could have gotten as low as -10% (10% average minus 20%= -10%) or as high as 30% (10% + 20% = 30%). That's a big swing- and remember it was even greater if you look at the WHOLE graph which is wider still.

NO GRAPH

Let me ask this question? Which investment do you want to use? Before answering there are two significant issues that need to be addressed- one commented upon in many magazine, the second rarely addressed by anyone. Both are equally important. The first involves statistics over a period of time. Simply stated, the longer you hold an investment, the lower becomes its standard deviation (asset rates of returns over successive holding periods are independent). The good and bad years supposedly cancel out. This standard deviation can be determined by dividing the standard deviation by the square root of the number of years held. So a 20% standard deviation held for five years shows a 8.95% (20%/2.24) standard deviation. Everything seems so much better when you see that. Supposedly you can then expect the same average return of 10% but only a 8.94% downside drop in 68% of the time. That's sure a lot better. That sure what is presented in any of the articles. That's fine and dandy and it's a lot easier to swallow a 8.94 % movement than it is a 20% movement. If I go to 10 years, the deviation drops to 6.32%. why this looks better and better. At 20 years, it's only 4.72%- probably within the acceptable risk range of most people.

What is never discussed is the fact that what happens if there is a big loss that actually DOES happen in the initial ownership of the assets. What happens if there is a one time standard deviation drop in the first five years? A real mess, that's what. In order to determine what actually goes on, you take, for example, the projected average and multiply by the high and low standard deviation to the power of the number of years. $100 x (1.1894) 5th or $238 on the plus side or the low side $100 x (1.101) 5th power = $105 on the bottom. If the returns simply average the overall 10%, you would get $162. If things really went great, you could get as high as $238. But if things went bad, you only get $105. That's about 35% less money than you expected. Can you live on 35% less money than expected???????

Bottom line: Time does lower standard deviation. But the longer you hold an investment, the more money you are putting at risk for something that actually can go wrong.

The best example of this relates to insurance companies and natural disasters. As an insurance company insures more homes across the United States, the odds of something devastating happening to all the homes or businesses is relatively remote. The risk is acceptable. But the hurricanes in Florida, two 500 year floods in the middle west in back to back years and the earthquakes in California all happened at "once". Insurance companies have been devastated by the losses. The same thing could happen to you IF YOU WERE NOT PAYING ATTENTION to your investments. The big difference is that stocks and bonds are liquid. If a depression is forthcoming, astute should and COULD be out of the market well before disaster strikes.

Correlation- this is a fairly technical and evolving analysis where the investor uses different types or allocations of securities so that if one type does bad, perhaps another type many do good. That's because not all types of investments move in the same direction for the same reason or at the same time. For example, real estate does not react the same way as the overall stock market- nor necessarily do foreign stocks- nor necessarily do bonds and so on. It is our contention that 401(k) investors should have studies performed on certain funds to determine how well they correlate with each other.

Correlation for twenty year period 1970- 1992 (Life Insurance Selling)

CORRELATION: (Life Insurance Selling) 1970- 1992

Year	1	2	3	4	5	6	7	8	9	10	11	12
1 Cash	1.0
2 Domestic Stock	-0.8	1.0
3 International Stock	-0.8	.52	1.0
4 Real Estate	.23	-.05	-.07	1.0
5 Domestic Bonds	.05	0.4	.25	-.24	1.0
6 NonDollar bonds	-.11	.13	.59	-.09	.17	1.0
7 Balanced Funds	-.06	.98	.51	-.15	.53	.17	1.0
8 Managed Futures	.06	.02	-.07	.11	.04	-.07	0.0	1.0
9 Venture Capital	-0.8	.51	.41	.09	.17	.17	.50	.06	1.0
10 Leasing	.64	.05	.01	.08	.20	-.01	.09	.03	-.03	1.0
11 Gold	-.11	0.0	.26	.15	-.08	.29	0.0	0.1	.04	-.18	1.0
12 Equity REIT	.11	.81	.66	-.3	.43	.28	.81	-.14	.89	.13	-.01	1.0

This simply compares how one investment related to another for the particular time frame. The correlations will change due to a myriad of factors, but their relative position over a period of 20 years may be used as a reasonable guide for the immediate future.

Nonetheless, buying domestic stock and adding real estate, bonds and foreign stock might be a worthwhile consideration since the movement of these assets have a negative or low correlation- or gold which has no correlation to stock.

BOND CORRELATION

Correlations for Annual Total Returns for Long Term Government Bonds in U.S. Dollars (1993)

Australia Canada France Germany Italy Japan Netherlnd Switz U.K. U.S.

Australia 1.00

Canada .18 1.00

France .30 .18 1.00

Germany .12 .15 .69 1.00

Italy .38 .12 .73 .45 1.00

Japan .29 -.08 .56 .59 .44 1.00

Netherlands .13 .29 .77 .93 .49 .54 1.00

Switzerland .11 -.10 .68 .88 .37 .67 .86 1.00

Britain 37 .09 .39 .41 .32 .60 .42 .41 1.00

United States .08 .80 .44 .36 .35 .04 .50 .14 .15 1.00

There's no question that by buying different bonds in different countries, you might be able to offset the risk of one country- say the U.S. - with Japan since the correlation of Japan to the U.S. is a minuscule 0.04. Of course on needs to recognize that the interest rates on Japanese instruments is exceeding small. While true that risk has been lowered, so has the return. In conjunction with that is the fact that the Japanese Yen has risen considerably against the U.S. dollar, so one does get back more dollars under the currency exchange. Did you understand all that? If not, don't invest because you do not understand what can happen.

Derivatives- These are securities whose value is usually tied exclusively to the movement of something else (stock, bond, index) and may be heavily leveraged- the real problem. In the worst case scenario, they are a form of betting. For example, assume you had a derivative costing $10,000 that could be worth $1,000,000 if interest rates in Guam dropped 2% in by August 15th- but by the same token could cost you $1,000,000 if interest rates increased 2%. You can see that if everything went right, your investment or funds could outshine many others. However, if you guessed wrong, significant losses could occur. You might also see that this play on interest rates is rather unusual- interest rates in Guam? And because of that, it also undoubtedly means there is minimal liquidity to the contract- meaning no one else would want to be part of it by buying either position from one of the parties. So ,I have a thinly traded issue on an almost totally esoteric issue, solely between two independent parties with no national exchange reviewing and monitoring. If anything goes wrong, it REALLY goes wrong.

Not all derivatives are bad- in fact most are used to hedge (reduce) risks, not increase them. These can reduce the risk of a fund but will also reduce the overall yield/return since you need to pay something for the derivatives. If a fund is using derivatives, you or your advisor should be sure how they are being used. If you don't know and won't find out, don't blame the fund for going down if the derivatives bite back.

Referrals: Never addressed as a risk per se, but undoubtedly one of the greatest causes of lost money in the United States. Literally everyone in the insurance and finance business likes to get referrals- it's the life blood of the business. And you may like a referral from a happy customer since you'd like to be happy to. However, as stated in "Who Can You Trust", just about NO ONE ever does any review on the person being referred. It's, "well if Bob says Jack is a good stockbroker/planner/adviser, I won't have to check up on Jack. After all, Bob and I have played golf together for years and I TRUST HIM!". Or, "Jane is a wonderful mother and the president of our PTA and I TRUST HER!" This unsubstantiated "trust" is the same excuse people used at Lincoln Savings and Loan, with Prudential Limited partnerships, with Metropolitan retirement life insurance and literally all the other times when people have lost money. It may be fine to trust a doctor, veterinarian, dentist or someone of a highly skilled background. But unless you do a full background check on a financial adviser, insurance agent, stockbroker, real estate broker or other "professional" where licensing requirements are minimal, you CANNOT assume competency. So we'll say it again

NEVER, NEVER, NEVER GIVE MONEY TO ANYONE, SAVE FOR AN FDIC CD, WITHOUT GETTING A WRITTEN STATEMENT OF THE INDIVIDUALS EDUCATION, QUALIFICATIONS AND BACKGROUND. NEVER!!!!

This statement will help you avoid 80% to 85% of every reason people lose money.

Affinity Scams: State attorney generals say this is one of the greatest frauds on the public today. It involves all races, religions, nationalities, sexes, affiliations, beliefs- in other words, anyone.

People may be a little cautious about investing with just anyone. But put them in a room with people of similar interests and backgrounds and they tend to drop their guard and dump money into totally bum investments that they would not normally have done. It could be someone that you play golf with, at your PTA, a member of AA- or even AAA. It's particularly noticeable with members of the same race or nationality because that's where people may tend to feel most comfortable. That's also where the sharks want to swim. They focus on the similarities of interest and you end up investing in absolute scams. But don't think the rich are any better at doing their homework. A WSJ article noted that in 1994, some of the richest and most respected institutions and names in the WORLD (University of Pennsylvania, The Franklin Institute, dozens of Christian schools, colleges and relief organizations and names like Rockefeller, John Pepper- president of Proctor and Gamble, John Whitehead- former co-chairman of Goldman & Sachs, and the holy of hollies- Peter Lynch) got caught dumping millions and millions into Foundation for New Era Philanthropy. This supposed CHARITABLE ORGANIZATION's director said that, if you gave him money, he would have anonymous benefactors double the money in six months. (Hello out there, wasn't anyone home?) Another article noted that he had a past criminal record- which nobody checked- and, apparently, the money went directly into his brokerage account. (Hello out there, wasn't anyone home?) All this happened through referrals at clubs and functions these people were affiliated with. So I have three reasons the money was lost- referrals, affinity scams and, undoubtedly since almost all the losers were men, the insidious male ego (see glossary).

Nobody did any homework. All were greedy. All were lazy. All thought the other person had done all the checking. C'mon, 100% in six months, even for charity? They must have all just fallen off the broccoli truck. It was the standard Ponzi scheme.

FIGURES CAN LIE AND LIARS CAN FIGURE: (1997) Mark Carhart, a finance professor at the University of Southern California, did a study on diversified equity funds between January 1962 and December 1995 to incorporate those funds that went out of business during that time and what impact they might have had on the return of the market overall.

Out of 2,071 funds, 725 (35%) are no longer around due to combining with other funds or just going out of business. His study showed that about 3.6% of all funds terminated annually.

If you analyze all the diversified fund returns during that time, it shows a 10.7% compounded. That compares favorably with the S&P 500 at 10.6%. But if you include those funds that are no longer around (and must have a bad return to have gone out of business), the average return drops to 9.5%.

He also found that those funds that took the greatest risk had the greatest chance to fold (seems logical). 242 of 614 aggressive growth funds terminated between 1962 and 1993 (39.4%) 277 of 827 long-term growth funds (33.5%) and 206 of 630 (32.7%) growth & income funds went under (not much better statistically).

Part of the key to that study is just how much extra return the aggressive funds provided. Statistics indicate that during this period, growth & income funds returned 10.8% compounded annually; long-term growth funds, 11.5%; and aggressive growth funds, 13.5%. But, after deducting for the returns of terminated funds, growth & income funds returned 10.39% compounded annually; long-term growth, 10.44%; and aggressive growth, 11.6%- a considerable drop.

The 725 funds showed very low returns during their last five years of existence (expected) were scary in more than one way. They underperformed the average fund by about 20 points (remember 44 Wall Street?) They also charged much higher annual operating expenses; 1.44% versus 1.07%. (If you don't think nothing like this could happen now, recognize that the Steadman funds charged up to 3% and just recently went out of business).

The point that needs to be addressed is that one cannot invest in a vacuum. Most of these terminated funds may have had some good years, but when they stumbled, many investors paid no attention, didn't want to admit they made a mistake or simply held on hoping the funds would come back (remember that's exactly what happened with Steadman and other funds.) If you had paid attention, you would have rebalanced the portfolio to adjust for the lousy performance.

If you don't understand the basic risks and rewards, do not consider yourself competent to invest large sums of money. Even when you select an adviser, don't use TRUST as the sole determining factor. READ, and do a lot of homework before you ever give money to anyone.

These are the basics- there are many more. But if you got this far and paid attention, you should do well with investments- assuming you can also use a financial calculator.

STOCKMARKET NEWSLETTERS: (1999) Marc Hulbert writes a newsletter that indicates which adviser newsletters have truly outproduced everyone other adviser newsletter. He notes that Al Frank "has made more money than any other newsletter since mid-1980, earning a 17.7% return versus the broad market of 16.1% (Wilshire 5000 Index)." But those are just gross numbers of return. They do NOT address risk- which is exactly the point that I have tried to get investors to recognize for years. Hulbert went on to say that "in achieving those returns, when measured by volatility, his portfolio was two and a half times riskier than the market as a whole".  It is not just the return you focus on- "adjusted for risk, Frank's returns lagged the index by 3.5-point percentage points the price paid for focusing on raw, unadjusted performance alone."

MARKET REBOUND: (1999) Wondering about the  market? Here are some statistics on how fast the market has rebounded from losses since 1987. Just remember, the past is not an indicator of what will happen in the future. (S& P 500 Index)

Date	Monthly Drop	Following Month	Following 6 months	Following 12 months
Oct 87	-21.63	-1.4	5.5	14.7
Nov 87	-8.19	12.0	15.8	23.2
Jan 90	-6.71	4.0	10.1	8.4
Aug 90	-9.03	-5.3	15.9	26.9
Sep 90	-4.92	6.05	24.8	31.3
Jun 91	-4.57	7.14	14.2	13.4
Nov 91	-4.13	9.49	12.3	18.4
Mar 94	-4.36	2.94	5.3	15.6
Jul 96	-4.42	7.86	24.2	52.1
Mar 97	-4.11	12.42	26.3	48.0
Aug 97	-5.60	1.95	17.6

RISK: (1999) More on deceptive risk. Some of you may know of the Gifttrust. You put money in the fund and cannot take it out- it is left in trust for your children or other beneficiaries as specified by the trust. Literally every financial journalist noted that the initial spectacular returns were due to the fact that the managers could take extra risks since they did not have to be concerned about the investors pulling money out because it had to be left in for at least 10 years. Therefore they were (supposedly) assured of beating the market. From 1983 to 1995 the average return was 25% and in 1991 it had a 85% return. Very good! (Remember though, it says NOTHING about risk per se. The raw numbers say nothing about volatility. The numbers say nothing about the fact that 80%+ of managers are unable to beat an index.) So now comes 1996 and for the last three years it has had an annualized 6.2% LOSS. An article on the fund noted that "investors say they have no problem accepting risk SO LONG AS IT DOES NOT MEAN ACCEPTING LOSS. "

VOLATILITY: 1998 may end up being only the year in this decade and only the fourth since 1970 where the volatility exceeded 20% (One standard deviation = 68% of the time). The annualized volatility for the past two decades was 12.8%. The U.S. Treasury bond had a standard deviation of 11% while municipal bond index (Bond Buyer Index) had a volatility under 5%.

Risk (FED Reserve Board of Boston 2000) You have no idea how good most of the articles are from the FED- though I admit that I don't understand them all. Regardless here is a very good one called Failures in Risk Management by Ralph C. Kimball

"Risk management has received increasing attention in recent years, both from academics and from practitioners. The heightened interest is the result of a number of coincident secular trends, including increased investment in volatile emerging markets and the growing role of capital markets in both developed and emerging economies, as well as the introduction of volatile financial innovations. Risk management has also attracted attention as a result of the repeated and well-publicized failures associated with its implementation. Despite the increased attention paid to risk management, frequent instances still occur when sophisticated investors or firms experience sudden, unexpected, and devastating losses. This article discusses failures in risk management, why they occur, and what can be done to reduce their occurrence. The author discusses the nature of risk and the objectives of risk management. He argues that intuitively attractive conceptual simplifications often create significant errors in risk measurement. He describes such failures in risk manage-ment and goes on to discuss the implications, both for managers and for regulators." (PDF)   

Risk (NY Times) (RiskMetrics 2002) Using the past performance of the 30 stocks in the Dow Jones industrial average, the firm recently estimated how much risk a worker would be assuming in his retirement account if it contained varying stakes in his company's shares. For instance, a worker at Microsoft (news/quote) who has one-third of his 401(k) in Microsoft shares and the remainder in an index fund that mirrors the overall stock market would be assuming almost 30 percent more risk than he'd have in the index fund alone. If the Microsoft employee had only 10 percent of his portfolio in the company's stock, however, his risk would be only 12 percent greater than the overall market's.

In recent years, Microsoft stock has been the dominant holding in the company's 401(k). According to the most recent figures available, a little over a year ago Microsoft shares made up 46 percent of the company's 401(k) plan. Employees with that much Microsoft stock, RiskMetrics said, have nearly 40 percent more risk than the market.

With Hewlett-Packard (news/quote), RiskMetrics found that a 30 percent holding by employees in a 401(k) would mean 42 percent more risk than in a stock index fund. According to the most recent figures available, 27 percent of the company's 401(k) plan assets were in the stock of Hewlett-Packard and its spin- off, Agilent Technologies (news/quote).

Concentrated holdings in some companies' shares pose little hazard to workers. RiskMetrics found that even large holdings of four Dow stocks — Coca-Cola (news/quote), Johnson & Johnson (news/quote), Merck (news/quote) and Procter & Gamble (news/quote) — would not produce much greater risk than a portfolio invested in the overall market.

But weighing all the 30 Dow stocks, a one- third holding in a 401(k) would produce, on average, 21 percent more risk than a portfolio that reflected the overall market. Given the greater volatility in Nasdaq stocks, similar holdings in those companies' shares would generate even greater risk."

As regards the commentary about Coca Cola, etc. and that they would not produce much greater risk than the market- I don't buy that. I bet if you had put Enron in the formula before it melted, it would also show a low risk simply because its volatility and beta were low. Also, remember, it was the darling of the market. The problem simply is the fact that what was once good may have been nothing more than a smoke screen. Or something devastating could happen to the company. What happens if some new ingredient in Coke was found to cause major illness and death? Wouldn't this solid company drop like a stone? Sure. It's called unsystematic (business) risk and it can eliminated by adding the proper number of stock (about 50 in total). The point is that the underlying risk is inherent in pure numbers of history and what can go wrong. Think about this- was there any visible risk in tech stock as they kept going up and up? Nope. Was it inherent? Yep!

Risk article by David B. Loeper (2002) . He discusses the problems with return assumptions in the absence of risk and how advisors can use risk and return to do a better job of preparing their clients for the future.

Time Diversification: (2003) Some practitioners take the view that the longer the horizon, the more investors benefit from investing in equities. Young investors, for instance, are typically advised to allocate more to equities than those whose retirement is imminent, on the grounds that equities are less risky over long horizons. A common rule of thumb is that the percentage of stock allocation should equal 100 minus an investor’s age. Several academic authors have argued to the contrary that greater equity allocations are irrational with a constant investment opportunity set. Samuelson (1969) and Merton and Samuelson (1974) claim that, in a standard utility maximization framework, allocations of investors with constant relative risk aversion should be unaffected by the investment horizon. This important difference of opinion has become known as the time-diversification controversy.

Another line of reasoning has been advanced by Bodie, Merton, and Samuelson (1992), who explain that younger workers should bias their investment toward equities on the grounds that unlucky equity losses can be offset by working harder later; older workers do not have this option. This flexibility in labor supply leads to a greater risk tolerance. Finally, intertemporal hedging of changes in the investment opportunity set may provide another explanation.3

Beyond the theoretical arguments, there may be empirical reasons for equities to be less risky over long horizons. For instance, there could be mean reversion in long-term equity returns. Several authors have claimed that greater equity allocations are justified on the grounds that shortfall risk declines as the horizon is extended.4 Poterba and Summers (1988) argue that variance ratios of long-horizon returns to short-horizon returns are lower than one would expect under the random walk assumption, which they interpret as evidence of mean reversion in international stock data. If so, long-horizon returns are relatively less risky, justifying an increased allocation to equities.

A major problem with all these studies is the limited data. Using data on US equities since 1926, I have only seven truly independent observations. Tests based on such small sample sizes are bound to have low statistical power. In addition, statistical tests often rely on asymptotic properties and may lead to biased inferences in small samples.

Table IV. Long-Horizon Return and Volatility, Annualized Real Capital Indices

Average returns and volatilities for real capital appreciation returns on global equity markets across various horizons. Returns beyond one year are annualized. Statistics for one-year to ten-year data involve overlapping observations. Average ten-year return, for instance, is the arithmetic average of all ten-year returns. Average return over the total period is the geometric growth.

Average Return Volatility

                                                1-Mo 1-Yr 5-Yr 10-Yr Total 1-Mo 1-Yr 5-Yr 10-Yr

Country ----- (Annualized) ----- -- (Annualized) --

US                                           0.46 6.21 3.79 2.78 4.31 4.57 20.89 9.39 5.99

Canada                                    0.37 4.77 2.74 2.04 3.05 4.79 20.49 8.13 4.32

UK                                            0.30 4.04 1.90 1.28 2.35 4.53 19.09 8.57 5.71

Austria                                     0.27 5.08 2.69 2.48 1.62 5.28 27.74 13.82 9.09

Belgium                                   0.12 1.77 -0.34 -0.71 -0.32 5.47 21.12 8.44 5.29

Denmark                                 0.22 3.38 1.37 1.01 1.86 3.66 20.09 6.96 4.91

Finland                                    0.29 5.60 2.34 1.43 2.07 4.93 28.94 14.11 9.74

France                                     0.26 3.68 1.34 0.42 0.93 6.13 25.18 12.72 7.93

Germany                                 0.55 8.65 3.13 2.36 1.90 7.33 44.36 14.14 9.88

Ireland                                    0.22 3.63 1.40 1.45 1.46 4.34 21.96 9.88 6.58

Italy                                        0.27 5.23 0.96 0.63 0.06 7.37 38.55 13.60 10.32

Netherlands                            0.22 3.49 1.78 1.25 1.59 4.28 20.08 9.18 6.29

Norway                                  0.37 4.50 2.31 1.55 2.90 5.16 21.05 8.33 5.84

Portugal                                  0.24 6.71 0.42 -0.38 -0.58 8.34 47.96 17.37 10.72

Spain                                       -0.05 0.20 -1.94 -2.92 -1.78 4.51 23.27 13.00 8.60

Sweden                                   0.45 6.04 3.85 3.12 4.11 4.79 21.56 9.28 5.80

Switzerland                               0.36 4.78 2.65 2.23 3.23 4.26 19.21 8.54 5.38

Australia                                   0.22 3.17 0.96 0.38 1.58 4.03 18.78 7.87 5.00

New Zealand                           0.06 1.41 -0.62 -1.02 -0.25 3.62 19.55 8.12 4.55

India                                       -0.08 0.36 -0.74 -1.36 -2.28 4.65 22.95 10.28 7.47

Japan                                       0.16 4.39 1.22 0.65 -0.81 6.69 30.29 17.96 14.86

Pakistan                                   -0.05 0.84 -0.18 -0.87 -1.77 4.39 21.40 8.12 6.22

Philippines                                 0.11 6.30 -2.65 -4.33 -3.64 10.73 70.47 19.94 13.65

South Africa                               -0.03 0.66 -1.03 -0.61 -1.76 4.59 22.07 9.41 6.75

Brazil                                       1.08 15.14 2.40 0.05 -0.17 14.97 64.22 22.09 9.78

Chile                                        0.63 9.15 4.24 2.72 3.00 8.77 39.65 19.14 12.48

Colombia                                   -0.17 0.09 -3.37 -5.82 -4.11 6.29 35.83 13.70 8.01

Mexico                                       0.45 9.11 4.54 2.71 2.28 7.05 47.31 17.10 10.83

Venezuela                                  0.07 3.43 -2.23 -2.79 -2.03 7.16 44.82 10.22 6.20

Israel                                         0.48 7.60 3.84 1.74 3.03 6.62 31.07 11.70 5.19

Average                                    0.26 4.65 1.23 0.38 0.73 5.98 30.33 12.04 7.78

Median                                      0.25 4.45 1.39 0.83 1.52 5.05 23.11 10.25 6.67

Index

Global                                        0.38 5.11 3.73 3.02 4.04 3.19 16.10 8.33 5.65

Non-US                                    0.32 4.38 3.36 2.93 3.39 2.87 15.57 8.08 5.85

Table IV also shows a wide dispersion in annual volatilities across countries, ranging from about 20% to 70% per annum. The median one-year volatility is 23%. In particular, the socalled emerging markets of Asia and Latin America display the highest volatility.16 US equities are among those with the lowest volatility, even though they enjoyed the highest growth

Education and risk: (2005) Like all forms of investment, that in education entails risk: in fact, compared to accepting a current job offer at a known wage, the decision to obtain more education exposes the investor to a risk of failure - because the program may turn out more difficult than anticipated or because the individual later discovers he lacks the necessary ability. He may thus lose the sum invested (including the direct fees, the living costs and the forgone salary in the alternative job). In addition, since the investment in education only bears fruit after a relatively long time span, the investor also bears the uncertainty over the market value of the degree at time of completion. Thus, the less risk-averse individuals should be more likely to obtain higher education. Brunello (2002) shows formally that the number of years of education a person optimally chooses depends negatively on absolute risk aversion.

* Compared to the risk-prone, the riskaverse are 6 percentage points less likely to be self-employed (corresponding to 36 percent of the sample share of the self-employed), have a 6-point lower chance of holding risky securities (corresponding to 42 percent of the sample mean), and have, on average, 110,000 euros less in total net worth, 75 percent of the sample mean. Correspondingly, individuals with a low degree of risk aversion (at the 10th percentile of the cross-sectional distribution) face earnings that are 60 percent more variable than those of highly risk-averse individuals (90th percentile).

Luigi Guiso and Monica Paiella

How to Think About Risk? (2005) The same issue keeps reappearing. How to deal with the risk associated with equity investments when evaluating the financial health of retirement systems? Some experts argue that retirement plans holding equities can make smaller funding contributions than those invested primarily in bonds. After all, stocks yield 7 percent, after inflation, and bonds only 3 percent. Nonsense, say others. The higher expected returns on equities reflect their greater risk. Any serious financial evaluation of retirement arrangements must “risk-adjust” these returns. After accounting for risk, the contribution needed today to fund future pension obligations is the same regardless of whether the fund is invested in equities or bonds. Is it possible to reconcile these two views? How should individuals, governments, and employers account for the expected additional returns from equity investment in pension funds? How should they account for the additional risk? Finally, and perhaps most importantly, how does this relate to the debate about creating private accounts with equity investments for Social Security? To sort out these difficult questions, this brief does three things. First, it describes how equities have performed over the last 75 years. Second, it explains how economists, accountants, and actuaries handle the high returns/high risks associated with equities in the real world. Finally, it explores the implications of the risk discussion for evaluating Social Security reform proposals. The conclusion is that the treatment of the high returns/high risks associated with equity investment depends on the extent to which the entity can manage the risk and the purpose of the calculation. In the case of Social Security reform proposals, evaluations that focus solely on the expected return to equities, without adjusting for risk, overstate the contribution of private accounts to retirement income security.

Risk aversion:  . Decisions with uncertain outcomes are often made by one party in settings where another party bears the consequences. Whenever an agent is delegated to make decisions that affect others, such as in the typical corporate structure, does the agent make decisions that reflect the risk preferences of the principal? We examine this question in the simplest possible setting using controlled laboratory experiments.We find a remarkable result: when an individual makes a decision for an anonymous stranger, he tends to exhibit less risk aversion. This reduction is relative to his own preferences, and also relative to his belief about the other’s preferences. This result has significant implications for the design of contracts between principals and agents.

A Morningstar journalist had this to state about fiduciary duty and standard deviation- (2006) "In the following examples, basic rules of arithmetic show how reducing volatility (or risk) can reduce loss. (We will also see how reducing volatility risk can enhance gain. By the way, I equate "volatility" with "risk," which I define as standard deviation in this article. While using standard deviation as a measure of risk is not ideal (e.g., it encompasses both bad "uncompensated" risk and good compensated" risk), nonetheless it can help illustrate a basic concept: the reduction of a portfolio's volatility reduces loss and can also enhance gain."

My reply- I understand the use of "risk" and standard deviation being used interchangeably. I totally disagree with it but I understand that most advisers like to use it.

That said, whenever risk is identified, it is mandatory to provide the caveat to the limited knowledge of volatility over time. It is not whether the risk goes down over time, it is the fact that the risk of loss goes UP the longer you hold a security. From a paper I just completed (in part),

"The basics of standard deviation go one step further- though without a full understanding of the following paragraph, it is clearly reflects a distortion of risk by many planners. Standard deviation is reduced the longer you hold a security. The statistical support is as follows: assume a standard deviation of 30%. If the security was held for five years, the standard deviation is reduced to "only" 13.42%. (Divide the annual deviation by the square root of the years held- in this case 5 years. That number is 2.236. And if you held it for 10 years, you divide by 3.16 for a volatility of just 9.48%. If you had started with just 20% volatility, then a 5 year deviation would result in a 8.94% volatility and a 10 year deviation of only 6.32%.) The appearance to the novice should be evident- simply buy and hold on to a portfolio and the "risk" will be reduced each year to a most acceptable level. This is how risk has been presented. It is wrong. As stated, standard deviation is not risk. Secondly, the risk of loss actually goes up over time.

Actually an investor can expect about 50% less funds than anticipated. I submit that there is a fiduciary duty to provide this material to clients. But it is not done. Why? Well, first and foremost, the fundamentals of investing have never been taught to brokers. A series 7 rep has not been taught diversification, beta, alpha, correlation, standard deviation etc., and, quite importantly, has no inherent ability with a financial calculator from standardized licensing training. There is no compulsory education in this area at all for securities brokers nor insurance agents. This statistic is not in the CFP required study.

Here are the statistical measures of standard deviation and projected losses. (Admittedly, the opposite side is true of returns. It is possible to have a huge amount of money during retirement and at death. But that is not the real world of planning during retirement- it is to have enough funds given most market calamities.) The longer you hold a security, the greater the risk of a major loss. Assuming a 20% initial standard deviation and a hold period of five years, one uses the formula (1- .0894)5th and it yields .626. This means that the final five year wealth may be only 63% of projected (and that is just for one standard deviation- a 68% probability in itself. If one uses three standard deviations, the risk is even greater). The statistic represents a 37% loss from projected value- far greater than a one year 20% swing. Per Investments by Bodie, Kahn and Marcus, Richard Irwin Inc. 1989, page 224, ".....time diversification does not reduce risk. Although it is true that per year average rate of return has a smaller standard deviation for a longer time horizon, it is also true that the uncertainty compounds over a greater period of years. Unfortunately, this latter effect dominates in the sense that the total return becomes more UNCERTAIN the longer the investment horizon". "Investing for more than one holding period means that the amount at risk is growing. This is analogous to an insurer taking on more insurance policies. The fact that these policies are independent does not offset the effect of placing more funds at risk." I emphasize the date of the book of 1989. The formula for the position of loss is not a new calculation just "invented". It has been known far in advance of the 2000- 2002 financial debacle but remained universally unacknowledged by the securities and planning industries. Consumers are unaware of this material. They cannot be expected to search it out either. However, true advisers must seek it out, understand it, use it and properly convey the implications to consumers."

Anyone who uses standard deviation as a measure of risk and/or to gauge value at the end of a period owes a fiduciary duty to provide the true numbers that an asset should be projected to have about half of what is programmed over time. Passive investing may be fine; market timing might be bad; stock picking is difficult, low fees are best, etc. So what? It's how much money you can feel secure in achieving.

A (rounded) 10% annual standard deviation portfolio held for 10 years shows that a portfolio would have 72% of projected value; if held for 20 years, only 40% should be projected. And those numbers reflect just one standard deviation. The communication of mandatory risk is how much money can be expected. Any time volatility and standard deviation are utilized in any projection, an adviser must show that the risk of a significant reduction in asset value is increasing. Otherwise a breach of duty has occurred.

Risk and Reward

5-Year T-Note Portfolio 10% Equity Portfolio 20% Equity Portfolio 30% Equity Portfolio 40% Equity Portfolio 50% Equity Portfolio 60% Equity Portfolio 70% Equity Portfolio 80% Equity Portfolio 90% Equity Portfolio S&P 500 Index W/Divs

1973 4.6 2.6 0.6 -1.3 -3.3 -5.2 -7.1 -9.0 -10.9 -12.8 -14.7

1974 5.7 2.2 -1.2 -4.6 -7.9 -11.1 -14.3 -17.4 -20.5 -23.5 -26.5

1975 7.8 10.6 13.4 16.3 19.2 22.1 25.1 28.1 31.1 34.1 37.2

1976 12.9 14.0 15.2 16.3 17.4 18.5 19.6 20.7 21.8 22.8 23.8

1977 1.4 0.5 -0.3 -1.2 -2.1 -2.9 -3.8 -4.6 -5.5 -6.3 -7.2

1978 3.5 3.9 4.3 4.6 5.0 5.3 5.6 5.9 6.1 6.4 6.6

1979 4.1 5.5 6.9 8.3 9.8 11.2 12.6 14.1 15.5 17.0 18.4

1980 3.9 6.7 9.5 12.4 15.2 18.1 20.9 23.8 26.7 29.5 32.4

1981 9.4 8.0 6.5 5.1 3.6 2.2 0.7 -0.7 -2.1 -3.5 -4.9

1982 29.1 28.4 27.7 27.0 26.3 25.5 24.8 24.0 23.1 22.3 21.4

1983 7.4 8.9 10.3 11.8 13.3 14.8 16.3 17.9 19.4 21.0 22.5

1984 14.0 13.3 12.6 11.8 11.1 10.3 9.5 8.7 7.9 7.1 6.3

1985 20.3 21.5 22.7 23.9 25.1 26.3 27.5 28.7 29.8 31.0 32.2

1986 15.1 15.6 16.0 16.4 16.8 17.1 17.5 17.8 18.0 18.3 18.5

1987 2.9 3.6 4.2 4.7 5.2 5.5 5.7 5.7 5.7 5.5 5.2

1988 6.1 7.1 8.2 9.3 10.3 11.4 12.5 13.5 14.6 15.7 16.8

1989 13.3 15.1 16.8 18.6 20.5 22.3 24.1 25.9 27.8 29.6 31.5

1990 9.7 8.5 7.2 6.0 4.7 3.4 2.1 0.8 -0.5 -1.8 -3.2

1991 15.3 16.9 18.4 20.0 21.5 23.0 24.5 26.1 27.6 29.1 30.5

1992 7.2 7.3 7.3 7.4 7.5 7.5 7.6 7.6 7.6 7.7 7.7

1993 11.2 11.1 11.0 10.9 10.8 10.7 10.5 10.4 10.3 10.1 10.0

1994 -5.1 -4.5 -3.8 -3.2 -2.5 -1.9 -1.3 -0.6 0.0 0.7 1.3

1995 16.1 18.1 20.1 22.2 24.3 26.4 28.5 30.7 32.9 35.2 37.4

1996 2.1 4.1 6.1 8.1 10.2 12.2 14.3 16.5 18.6 20.8 23.0

1997 8.4 10.7 13.1 15.6 18.0 20.5 23.0 25.5 28.0 30.6 33.2

1998 10.2 12.2 14.2 16.1 18.0 19.9 21.7 23.5 25.2 26.9 28.6

1999 -1.8 0.4 2.6 4.8 7.0 9.3 11.6 13.9 16.2 18.6 21.0

2000 12.6 10.3 8.1 5.9 3.7 1.5 -0.7 -2.8 -4.9 -7.0 -9.1

2001 7.6 5.7 3.8 1.9 -0.0 -2.0 -4.0 -5.9 -7.9 -9.9 -11.9

2002 13.0 9.2 5.5 1.8 -1.8 -5.3 -8.8 -12.2 -15.6 -18.9 -22.1

Annual Return 8.7 9.0 9.3 9.6 9.8 10.0 10.2 10.4 10.5 10.6 10.7

Std. Deviation 6.3 6.3 6.6 7.4 8.5 9.8 11.3 12.8 14.5 16.1 17.9

Worst Month -6.4 -5.7 -5.1 -5.2 -6.8 -9.3 -11.7 -14.2 -16.6 -19.1 -21.5

Worst 3 Months -6.9 -6.0 -6.0 -7.7 -11.0 -14.2 -17.3 -20.5 -23.5 -26.6 -29.5

Worst 12 Months -5.5 -4.7 -7.7 -12.2 -16.5 -20.6 -24.6 -28.4 -32.0 -35.6 -38.9

Worst 36 Months 2.3 5.2 7.1 9.1 1.8 -5.8 -13.0 -19.8 -26.1 -32.1 -37.6

Worst 60 Months 16.3 20.2 23.0 24.4 20.2 15.9 11.6 7.3 3.1 -2.3 -7.9

Risk:  (2006) When risk is measured as the standard deviation of returns across time, this implication is confirmed — standard deviations are in fact lower. However, a hedge fund manager or 130/30 manager has more choices at his control, like short selling and derivatives. These choices create a risk that we call implementation risk. Two managers with identical standard deviations, implementing the same strategy, can have substantially different performance results, primarily because of the way they employ the tools available to them. Implementation risk is cross-sectional, whereas return risk is cross-temporal. Two low-volatility return paths can lead to substantially different wealth accumulations.

implementation risk is the price that is paid for what hedge fund marketers call “free leverage.” The pitch works like this: By going 130% long and 30% short you get 160% of your assets working for you (130% plus 30%), without any net increase in market exposure — a winner. Despite common belief, this free leverage does increase risk, namely, implementation risk. The key point is basic. Investors ought to know all of the risks they are taking. The benefit of long-short investing is in expanded opportunities. But this is a two-edged sword. Without skill you’re as likely to lose more as you are to earn more. Implementation risk tells you how much more, and reinforces the need for greater due diligence.

http://www.ppca-inc.com/Articles/P&I_Implementation-20060808.pdf

Risk, Return and Dividends    (2007) We characterize the joint dynamics of dividends, expected returns, stochastic volatility, and prices. In particular, with a given dividend process, one of the processes of the expected return, the stock volatility, or the price-dividend ratio fully determines the other two. For example, together with dividends, the stock volatility process fully determines the dynamics of the expected return and the price-dividend ratio. By parameterizing one or more of expected returns, volatility, or prices, common empirical specifications place strong, and sometimes counter-factual, restrictions on the dynamics of the other variables. Our relations are useful for understanding the risk-return trade-off, as well as characterizing the predictability of stock returns.

Volatility is Not Risk. (2007)

A shareholder from Los Angeles referred to the fact that many people talk about “sigmas” (the standard deviations of price changes) and equate volatility with risk. He asked why a rational person would substitute the opinions of the public (as reflected in volatility caused by mass decisions) for one’s own measurement of the inherent risk of a company.

Buffett: The measurement of volatility: it’s nice, it’s mathematical, and wrong. Volatility is not risk. Those who have written about risk don’t know how to measure risk. Past volatility does not measure risk. When farm prices crashed, [farm price] volatility went up, but a farm priced at $600 per acre that was formerly $2,000 per acre isn’t riskier because it’s more volatile. [Measures like] beta let people who teach finance use the math they’ve learned. That’s nonsense. Risk comes from not knowing what you’re doing. Dexter Shoes was a terrible mistake—I was wrong about the business, but not because shoe prices were volatile. If you understand the business you own, you’re not taking risk. Volatility is useful for people who want a career in teaching. I cannot recall a case where we lost a lot of money due to volatility. The whole concept of volatility as a measure of risk has developed in my lifetime and isn’t any use to us.

Munger: Finance taught in business schools is about 50% twaddle. We early recognized that very smart people do very dumb things. We wanted to figure out when and why…and who, so we could avoid them.

Comment: This was one of the best questions asked, and Buffett and Munger were characteristically straightforward in their answer. If volatility is risk, then an investment that does nothing but shoot sharply upward—that’s volatility, too—is risky. Similarly, suppose that an average worker regularly saves a modest amount from each paycheck and invests in T-Bills for retirement. It’s unlikely that this worker will amass sufficient purchasing power to retire comfortably, but because T-Bills aren’t volatile should we say that this investment approach is low risk? Investment managers may be quick with their opinions, but at least you can usually see their investment track records before you judge their insightfulness. Academics are free to spout nonsense, and there is usually nothing to alert the public that they may not know what they’re talking about. As the questioner implied, it’s a mistake to let Mr. Market—or Professor Beta—decide what’s risky and what isn’t.pooled income funds in existence less than three tax years must use a 4.8% deemed rate of return.

:High Idiosyncratic Volatility and Low Returns: International and Further U.S. Evidence   (2008) .Stocks with recent past high idiosyncratic volatility have low future average returns around the world. Across 23 developed markets, the difference in average returns between the extreme quintile portfolios sorted on idiosyncratic volatility is -1.31% per month, after controlling for world market, size, and value factors. The effect is individually significant in each G7 country. In the U.S., we rule out explanations based on trading frictions, information dissemination, and higher moments. There is strong comovement in the low returns to high idiosyncratic volatility stocks across countries, suggesting that broad, not easily diversifiable, factors may lie behind this phenomenon 

"If you're withdrawing money at the same time as your portfolio is going down, you just exacerbated a bad situation,

If you want formal corroboration, just look in my book No Nonsense Finance.

Another tactic for retirees to make their nest eggs last is simply to spend less. Many advisers say that a 4% initial withdrawal rate, increased annually to keep pace with inflation, is safe for most retirees. But "as the market takes a tumble, you want to be extra cautious about how much you take out of your portfolio," 

Or if you have a really good adviser, perhaps you are adjusting to cash as the economy tanks. Market timing? No. Common sense and a lot of reading and analsysis. 

Risk management: (NY Times, Bernstein 2008) The debacle from which the system is now trying to emerge suggests that prevailing risk-management strategies were managing the wrong risks. Surely, a reversal in home prices was a risk to be reckoned with, but it appears to have played no role, or at least none that mattered.
How will we deal with surprises — outcomes different from what we expect? What are the consequences of being wrong in our expectations? This is the point when risk management begins to live up to its real meaning. Risk means the chance of being wrong — not always in an adverse direction, but always in a direction different from what we expected.
RISK management, then, should be a process of dealing with the consequences of being wrong. Sometimes, these consequences are minimal — encountering rain after leaving home without an umbrella, for example. But betting the ranch on the assumption that home prices can only go up should tell you the consequences would be much more than minimal if home prices started to fall.

In this assumption, the word “only” is ridiculous. There are no “onlys” in the future. More things can happen than will happen.

Under those conditions, risk management should concentrate either on limiting the size of the bet or on finding ways to hedge the bet so you are not wiped out if you take the wrong side — if home prices do start to go down, or even stop rising. Risk management is fundamentally different from managing volatility, which is how many investors view it. Volatility is often a symptom of risk but is not a risk in and of itself. Volatility obscures the future but does not necessarily determine the future.