Proper investing is all about taking appropriate risks. An appropriate risk is one where the reward justifies the risk you are taking. Basically, you want to maximize your reward to risk potential. Unfortunately, some people severely limit their reward potential because they don’t properly understand how risk works – in particular, how volatility works. Probably one of the worst mistakes people make is to stay entirely in low volatility investments like back CDs their whole careers, totally missing out on the wealth growing potential of stocks because they’re afraid of seeing their account balances drop.
And volatility can be scary if you’re focused on your account value from day-to-day. Stocks are more volatile than bonds, which in turn are more volatile than money market funds and savings accounts. By volatile, I mean that the price goes up and down more rapidly. With a savings account, you can basically predict what your account will be worth tomorrow, next week, and next month. With bonds, they will change in price from time to time, particularly when interest rates are changing or people are scared by inflation or deflation, but the extent of their fluctuations are normally limited. Common stocks can change in price by huge amounts over short periods of time. A single stock can easily double in price or drop to half of its value over a given year or even a month or a week. Even a basket of stocks in an index can go up or down by 30-40% in a year. This means that you may look at your mutual fund portfolio one month and see that it is worth less than it was a month before. For some people, this is very disturbing.
Measurement of risk, however, is more than just volatility.
Risk = Volatility/Time
If you buy a stock mutual fund today and are planning to sell in a week or two, you are taking a huge amount of risk and would have been better off just leaving the money in a money market fund or even in cash if you really need the money in a week since you have very little time and stocks are very volatile. If you hold an investment like a stock or a bond for a long time, however, the risk decreases essentially to zero since the volatility is constant but time grows, causing risk to approach zero. (Look at the equation above and plug in 1 for volatility and 10, 100, and 1000 for time. The larger time grows, the smaller risk gets.)
Higher volatility investments like stocks, however, have a higher rate of return. Basically, because they are taking on more risk by putting their money into a company with no guaranteed rate of return, people require a better return on their money when things do work out with stocks than they do with bonds. If you buy just one stock, things may not work out and you may lose money. If you buy several stocks, however, those that do well will make up for the losses in those that don’t. And because they are priced for the risk you are taking, you’ll earn a better return investing in a portfolio of stocks than a portfolio of bonds. You’ll make a much better return than you will putting your money in bank CDs and money market funds.
If you are investing for five years or less, it makes sense to invest in bonds and cash investments like bank CDs since the risk of investing in stocks will be too great. You might end up with a good gain in stocks over a five-year period, but you might also end up with a loss. You might end up just about back where you started. With bonds, at least you’ll get an interest payment twice per year. Bonds also mature and pay you back a fixed amount when they do, so if you hold them to maturity by buying only bonds that mature within five years, assuming the company or government issuing the bonds doesn’t go bankrupt, you’ll know how much money you’ll have. This also makes the volatility for bonds less.
Now this is assuming you really need the money at the end of the five years. If it would be nice to have the money, but you could wait out a market downturn if one occurred, you might choose to invest in stocks anyway for the possible higher gain. During that time period if there were a big run-up in stocks before the five years were up, you would take advantage and cash out. If you ended up with less than you started at the end of the period, you’d go to plan B, using money from another source or just waiting longer to get whatever it was for which you were investing.
So how can you apply your newly minted knowledge about volatility and time? Well, let’s look at retirement investing. I invest for retirement through both a 401k at work and a personal IRA that I’ve had even since I was working as a lab assistant, making $5 per hour, in college. In my 401k, because I’m only in my forties, I have only stock funds and one REIT fund. The stock funds are scattered among large- cap, mid-cap, and small-cap index funds, a value fund and a growth fund, and an international fund. I tilt towards the small and mid caps since those will grow faster than the large caps over long periods of time.
In my IRA I have a few large positions in some select individual stocks and a few stock ETFs. I concentrate mainly on growth securities – those that offer little or no dividend – because I want them to put extra money back into growing their business rather than sending me a check four times per year that I’d just need to reinvest. These stocks are more volatile, but more volatility results in higher returns over long periods of time.
So what is my thinking behind these selections? Well, I’m planning to work until I’m at least 65, and maybe to age 70. I therefore have about a quarter century before I plan to tap my retirement funds. It might be even longer than that since I have other investments that I could use for daily living expenses for several years into retirement. This means I have a lot of time on my side, reducing the risk of holding mainly stocks and more even volatile stocks like small-cap growth stocks. I’m really not worried about a 40% drop in the markets like we saw in 2008 because I would expect the markets to recover over a few years afterwards if one did occur. As you saw in 2008, such events usually correct themselves within a year or two, as long as the government doesn’t try to “fix things.”
With stocks I can get a much better return than I will with bonds and fixed income assets, so I’m willing to accept the higher volatility over shorter periods of time. It will not matter ten or fifteen years from now if my portfolio value is cut in half next year. In fact, market downturns just mean I get to buy stocks cheaper, which will help me be even better off wen I’m ready to use the money. As I get closer to retirement – say within ten years – I’ll start to figure out how much money I’ll need and convert a portion of my portfolio to cash and buy some fixed income securities.
So when you’re developing your savings and investment plans, tilt more towards stocks when you have a long time to invest. The extra gains you make will give you more money and security when you need it later. If you really need the money soon, put the money in cash.
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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.