Ever wonder why you can make better returns in the stock market than you can in a bank account or even in bonds? The reason is a four letter word you should learn to love – risk. People are often told to avoid risk, or minimize risk. But as many people learn life, certain risks are worth it for the reward they generate. The scene in the picture is a pool with a neat little waterfall flowing into it at the end of a three-mile hike. (And believe me, the picture doesn’t do the area justice.) The hike was not risk-free. There was poison ivy everywhere. There were some rather steep areas on the trail, rocks that could have banged up a knee. There were even two foot bridges, each made of a single flattened log laid across the river with a very flimsy hand rail on one side. I could have easily twisted an ankle or even broken an arm, gotten dehydrated, gotten lost in the woods, or even been bitten by a snake or attacked by a rabid animal.
But only the ones willing to assume these risks were able to see that pool. Take a little more risk and climb up the rocks behind the pool and there was an even more spectacular spot waiting for you. Sometime you make the analysis and make the very valid decision that taking a certain risk is worth the reward. There are many others who would have decided the risk was too great – perhaps they are unsteady on their feet, can’t make the walk, or are just to scared to make the journey. They may or may not know the reward they are passing up.
Now some people take risks without really examining them and taking reasonable precautions. On this trip we saw a family heading down the trail as we were coming out, and it didn’t look like they had any water with them (or anything else). We had full backpacks with camping gear, fire starting materials, knives, water, water purification tools, food, compasses, and cell phones since we were planning to spend the night. Even on a day trip I would have everything listed except the camping supplies since there was a real risk I could get lost or injured and need to start a fire and refill on water. It is almost certain that I would dehydrated during the two hours it would take to get to the falls and two hours it would take to get back, even if I didn’t stay at the falls at all.
Taking a risk when it is almost certain, or even likely that bad things could happen is usually not worth the risk. The only exception is when the bad things that could happen aren’t really that bad. If I were hiking in a park surrounded by a city, I would only take water (assuming it was a long enough hike) since getting lost was almost impossible and if I ran out of water I would just be a little thirsty for a short time – I wouldn’t die of dehydration.
In investing, we take appropriate risks in order to extract a reward in the form of higher returns. We do things to manage that risk, so as to put the odds well in our favor unless we are simply taking a chance that might well go badly but the reward is worth the chance of loss and the loss won’t be devastating. You wouldn’t put all of the money you have for college into a single stock the year before tuition was due because the odds aren’t in your favor that your stock would be higher in a year and there is probably a one-in-ten to one-in-twenty chance that your stock may decline significantly in price over that year, leaving you unable to afford college. The result would be devastating and therefore, not worth the risk. You would put the money in a one-year CD since the risk that the bank would default on that CD is very slim, so the increased return over having your money sit in cash would be worth the risk. You should, however, put money that you are saving for retirement while you’re in your twenties into stock mutual funds, and perhaps even put a portion in single stocks, because the risk would be appropriate and the reward would justify the risk.
There is a reason that you get better returns when you take greater risks, and that because of something called discounting and the risk premium. Think of it this way: If you knew someone who was very reliable and who had a steady income, you might be willing to lend them $1000 for a year if they would give you $1050 back at the end at year. You would figure that the money wasn’t doing anything for you anyway and you could have $50 more for just letting them borrow it for a year.
If there were someone without a steady income (and who stiffed a friend of yours in the past) who also asked to borrow $1000 for a year, you might not lend it to him at all. If the terms were only for a month, however, and he would pay you $2500 at the end of the month, you might decide that the potential gain was worth the risk and make the loan. At this point you would be speculating since the odds might be 50% that he would repay and 50% that he would stiff you (in speculating, the odds are against you or only slightly on your side), but if he did repay, you would make a $1500 profit.
If you did this with four people of equal credit-worthiness, the odds are that two of them would pay you the $2500 and two would default and you’d lose your $1000. This would mean would make $3000 from those who repaid but lose $2000 from those who didn’t, leaving you with a $1000 profit. That is a lot better than you did with the trustworthy individual who was sure to pay you, but only pay $50 after a whole year. Here you made $1000 in a month.
And this is exactly what you do when investing in stocks. You are investing in things that do not have an assured return and therefore you are taking a risk, but if you manage those risks appropriately, you can almost guarantee you’ll do better than you did when investing in lower-risk assets. The greater the risks you take, the greater your possible return, but at some point you’re speculating and not investing and therefore taking a large risk of losing money. So how do you manage your risk when investing?
1. You invest appropriately for the time frame you have.
2. You diversify your investments to reduce single-investment risk.
3. You choose your investments appropriately based on your time frame and objectives.
I’ll go into these points in more detail in posts that follow. You can also get a lot more information on risks and returns of investments – far more than I can cover in a post – in my book, The SmallIvy Book of Investing. Please check it out and let me know what you think.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. 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. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.