One of the most common questions in investing is, “How do I reduce risk?” Perhaps the only question asked more is “How do I maximize returns?” What may be somewhat counterintuitive is that managing risk and getting the highest returns are not competing interest. In fact, they go hand-in-hand.
While it is true that the potential return is greater with more risky speculations (I won’t use the word “Investments” here), the actual return requires the potential return be realized. As an extreme example, someone purchasing a lottery ticket has a huge potential return. Because the risk of losing one’s investment and not getting that potential return is so great, however, one does not maximize return by buying lottery tickets. Likewise, one does not maximize return by day trading stocks.
So what are the risks of investing and how can they be reduced? The risks are as follows:
1. Risk of decay in the value of money (not keeping up with inflation).
2. Risk of loss of money (actual declines in account value).
3. Risk of not making sufficient returns, such that the money could have provided a greater return if invested elsewhere (loss of time).
I’ll address each of these one-by-one.
1. Decay of value:
The first risk is seldom thought of when talking about investment risk. One often thinks that the safest investment is to hold cash or perhaps a bank CD. While the chance of loss of capital is certainly low with these investment choices, loss of buying power due to inflation is an almost certainty if funds are left in “cash” investments for long periods of time. Employees who leave all of their 401k retirement savings in a money market throughout their careers have a very good chance of not having enough money to live on in retirement.
The only way of reducing the risk of decay in value is to invest in things that will grow in value faster than inflation. Over long periods of time, stocks, bonds, and real estate are about the only good choices. For this reason, money that will not be needed for a long period of time (say, 10 years) should be invested in these types of assets.
2. Loss of capital:
With any investment there is a risk of loss of money. Even real estate, which was thought to be immune to declines in prices, has proven to be capable of declines. Because many people coupled real estate purchases with extreme leverage (taking out loans with little or no equity), people have lost far more than they ever thought they could in a short period of time.
Likewise, stocks and bonds can decline in value. Single company stocks can drop in price very rapidly if bad earnings are announced, the company is involved in a large lawsuit or fraud, or even if (as the earthquake in Japan showed) natural disasters occur that cause sudden drops in demand for the company’s products. Bonds can become worthless and never be repaid if a company declares bankruptcy (as can shares of common stock).
The best way to reduce the risk of loss of capital is to diversify into several different investments. While any single investment may drop in price rapidly, investment in a large pool of different investments cannot possible decline in value forever (unless the entire economy goes under, in which case one would not be worrying about one’s investments). A good rule-of-thumb is to never put more into one investment than you would be willing to lose. Also, to achieve good diversification, investments in different sectors and types of assets is needed. Ideally these assets should not be correlated (move in tandem). For example, owning real estate in Florida and stock in a restaurant chain in the west would be only loosely correlated.
The other way to reduce risk of loss in value is to use a long time horizon. Because time tends to favor the investor (stocks, bonds, and real estate have a natural drift upwards in price), investing for long periods of time reduces risk. Note that this does not mean buying a single company and throwing the certificate in a vault for 100 years (few companies will last that long). It does mean, however, buying companies that have good long-term prospects and planning to hold onto their shares so long as those prospects don’t change, no matter what the market does to the price of the shares.
3. Risk of insufficient returns:
This risk is similar to loss of capital. In this case however, one’s investments don’t decline in value, they just sit there. For example, if one bought the s&P 500 in 1998 and held until the end of 2008, one would have had no return at all. Besides diversification which was mentioned above, the best way to ensure some return is to include dividend or interest producing assets along with those that provide potential for capital gains. Even if the price of stocks goes nowhere, if one owns some established companies that pay good dividends, one will still be making money.
The other way to reduce this risk is to always be investing. While it is true that one would have made no return if one put a large amount of money into the S&P500 in 1998 and sat on the position, if one invested regularly throughout the period – say, putting money in each month or each year – one would have still had a positive return even though the value of the index went nowhere.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.