From the September 2006 issue of Research Magazine • Subscribe!

Managing Risk

Research: What do affluent investors most need to understand about risk?

Sonnenfeldt: Very often, a security's volatility is the proxy used for risk, but in a sense, that's like driving down the road and seeing that the road behind was smooth even though you're approaching a cliff. The risk that most people think about has to deal with the historical dimension, but in reality, risk is all about what might happen in the future.

Most people also believe that risk is objectively measurable. In fact, most of our members who have built significant wealth did it through a series of transactions that were priced in a manner that would objectively indicate high risk, and yet they were successful with it because they assessed it not according to the market but through their own skills, expertise, social network and so on.

Finally, all sorts of financial instruments are pedaled to both unsophisticated and perhaps sophisticated buyers that claim they are shedding one type of risk or another, when in fact what they've done is shifted the risk elsewhere. A lot of these products have areas you don't want to look at too closely because the risk is still in there somewhere, and when it does occur, it can create dramatic results.

How does geopolitics play into investment strategy?

Global instability has risen, both through interconnectedness -- technology, especially communications -- and the potential of global infection on the disease front, as well as threats to greater portions of humanity because of weapons of mass destruction. In that sense, the more integrated the system, the more exposed the system becomes to threats that could have systemic impact.

First and foremost, this environment demands a more thoughtful approach to investing and an appreciation of the pitfalls that many people don't acknowledge until it's too late. You know that you should change the tires on the car every 60,000 miles. You know they won't pop at 60,001, but that doesn't mean you can drive forever. The world is more fragile. It's difficult to know where the individual tipping points are, but it becomes a more serious business the more the world becomes interrelated.

Have ETFs made the markets more or less volatile?

Conventional wisdom is that the creation of ETFs has added volatility to the market. It's intuitively obvious that what ETFs have done is simply become a mechanism where when you buy a share of that ETF, they're bound to buy every share in the basket. That certainly increased volatility on the smaller stocks in the basket -- if the ETF triggers a purchase of 50 or 100 companies, perhaps the smallest 20 of them probably have much higher visibility in the ETF now than they did on their own. And it's clear anecdotally that ETFs are creating a whole new opportunity for hedging.

In a risky world, can you be too diversified?

First, if your bets are too concentrated, and they're the wrong bets, you're going to be back working. But as a matter of statistics, there's a point at which the cost of additional diversification exceeds any benefit. Most people don't have even the most basic understanding of statistics, but when people ask me the No. 1 course to take in college, that's what I tell them.

Statistically, 18 randomly picked stocks from the NYSE would mirror something like 95 percent to 99 percent of the performance of the indices as a whole. Every stock you buy beyond No. 18 is adding transaction costs and management costs that probably exceed the benefit you would get if you just bought the index. At that point, you're not diversifying so much as "diworsifying," and that's one of the things we're concerned about. For the average private investor, the number of line items they should have on their balance sheet is probably no more than 30 and probably needs to be plus or minus 20 to be fully diversified. Now remember that two or three of those might be homes.

Furthermore, the overwhelming evidence is that asset allocation is a far more significant predictor of investment returns and success than the individual stocks you choose. For every sector you split your portfolio into, there's an amount of energy or money that you'll have to spend to find out who the best performer is. If you're going to spend the time on manager selection, spend it in the area where the best manager will give you the best performance.

Risk also generates opportunity. Where are the new opportunities?

The No. 1 investment opportunity is that it's easier to save a buck than make a buck. It sounds trite, but given the risks, if people are trying to achieve stability or economic independence, they have to look to their own expenses before they look to earnings. It's a lot easier to trim your expenses to add stability.

Beyond that, investing is a serious business and be aware of the risks. If you've really done your homework, you should be able to find private equity prospects that offer far greater returns than anything on the public equity side. Most people don't do their homework, which is where the advisor comes in.

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