Personal Finance Concepts You Should Know – Concept 2: Investment Risk

River1Understanding and using risk to your advantage is how you maximize your investment returns while still making sure you have the money you’ll need to eat next week.  Contrary to what you might think, you don’t generally want to minimize risk.  Instead, you want to take an appropriate amount of risk for your situation.  There are times in your life when you can (and should) take fairly substantial risks, then there are other times when you need to reel in those risks and just accept a low return for the security of knowing you’ll have the money you’ll need.

As you probably have gathered by now, you get a higher return when you take on more risk.  Now these two things are not exactly correlated – spending all of your retirement savings on lottery tickets probably won’t work out for you.  Instead, you want to take risks when the probable returns justify the risk that you are taking.  You also want to put other factors in your favor – namely time and diversification – to bring those risks down to a reasonable level when you’re investing in assets that carry more risk.

For example, if you have $10,000 that you need next year to buy a car, that money should probably go into a one-year bank CD.  Here you’re putting your money into something that has an almost guaranteed return, plus a virtual guarantee that you’ll not lose any of your principle, because you need to have the money there in a year, which is a relatively short period of time when it comes to investing.  Because you’re locking your money up with the bank for a year, they’re willing to pay you a bit more than they would if you put it into a savings account, a money market, or a shorter-term CD since they can then invest your money in ways that they could not without them knowing that they have a year before you would want the money returned.

If you didn’t need the money for ten years, however, new investment opportunities would open themselves up to you.  You could invest the money in a stock mutual fund, which have had returns of between 10-15% during most ten-year periods.  This compares with maybe 0.25% for your one-year CD.  The reason the returns are better is that the rate of return you’ll get is far less certain.  You can look at historic returns and see that most of the time your return will be in the 10-15% range if you hold for long periods of time, but over any given year or even a few years returns could be far less or even negative.

By investing for long periods of time, however, you smooth out this risk.  You don’t need the markets to do well this year or next year.  You just need to have some good years somewhere within your ten-year period.  History has shown that there may be some 35% down years, but there will also be years when a stock mutual fund will be up 40% or more.  There is also a natural tendency for stocks as a group to go up since the economy continually expands as more efficient ways to make stuff are invented.  By investing for long periods of time, you reduce your risk but still get higher returns that come from less predictable investments.

So, if you have money that you need within a year or two, it should be in cash because of the predictable return.  If you have several years to invest where you can wait for good things to happen, you should be invested in equities since they will provide a far better return.  They will also help protect you against inflation, which will decrease the value of the money you have in bank assets since the returns from even bank CDs are typically less than the rate of inflation (currently around 2%).

Now this does not mean that you should take dumb risks.  For example, stock options allow you to bet on the direction of a stock or index, and you can double or triple your money in a short period of time using them.  They have a short expiration date, however, (typically less than 3 months), so you need to be right both about the direction of the market or stock and when that movement will occur.  Making predictions such as this is about as scientific as predicting what the weather will be like in two weeks.  Given that about 90% of stock options expire worthless, and that when that happens, you lose your whole investment, stock options aren’t worth the risk.

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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.

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