The 2 Biggest Risks Faced by Every Investor
Reprinted courtesy of MarketWatch.com.
To read the original article click here.
Investing is about taking risks, right? After all, you’ll be hard pressed to find anybody willing to pay you to bet on a sure thing.
While you can’t avoid risk, you can understand it and manage it. When you do that, you are entitled to expect a return commensurate with the level of risk you take.
This is a big topic. But today I first want to focus on the nature of risk and why it’s important. Then I’ll look at the two biggest risks faced by every investor: Inflation and emotion.
The nature of risk
If you want to understand risk, a good place to start is to learn to think like a banker. Bankers understand risk and return very well.
For example: If Bill Gates and a college student picked at random walked into a bank on the same day, each wanting a loan, who do you think would get the better deal? Gates, of course.
While the bank takes virtually no risk by lending money to one of the world’s richest men, almost any college student represents a considerably higher risk.
If you were a banker and you could make only one loan — either to the student or to Bill Gates — what would you do? The decision isn’t as easy as you might think.
Your bank would get very little profit in lending money to Gates, who would bargain for a rock-bottom interest rate. A loan to the college student, on the other hand, could command a higher interest rate. If the student paid it back, your bank would make a lot more profit.
This banker’s dilemma makes it impossible to forget the link between return and risk. If you like above-average safety, you will get below-average returns. If you want high returns, you’ll have to take above-average risk.
One dictionary definition of risk is “the possibility of suffering harm or loss.” Other definitions use words like danger, uncertainty and hazard. Here’s my own somewhat unorthodox definition of investment risk: A possibility, which you consciously invite into your portfolio, that you could lose something important — namely money.
Defined that way, risk is not theoretical; it’s about really losing something. It’s not something that is imposed on you but something you choose, accept and possibly even encourage.
Think of the banker who knowingly loans money to the college student instead of Bill Gates.
Investors get paid for taking risks — if they do it intelligently. One reason people have so much trouble with this topic is that investors don’t get paid a premium return for doing what’s easy and popular and comfortable. (For a more complete discussion see Chapter 5 in my book Financial Fitness Forever.)
Now let’s look briefly at the two biggest risks faced by investors: Inflation and emotion.
The risk of inflation
This is the risk that money you save or earn will lose some of its purchasing power. Even if your five-year certificate of deposit is guaranteed, the dollars you get back probably won’t buy as much in five years as they bought when you took them to the bank.
Some investors in he 1980s felt giddy to be making double-digit interest on money-market funds. But if inflation is also in double digits, as it was back then, you’re more likely to fall behind economically than to get ahead.
This is an enormous risk for retirees. Somebody who retired in 1978 with an income of $40,000 probably felt quite comfortable. But 35 years later, in 2013, that $40,000 had lost nearly three-fourths of its buying power — being worth about $11,200 according to a Bureau of Labor Statistics online calculator. Looked at another way, that retiree would have needed about $143,000 last year to buy what he could have bought for $40,000 just 35 years earlier.
The most reliable way to protect yourself against this risk is to own at least some stock funds. For the most timid investors, the federal government’s I bonds (savings bonds with interest pegged to changes in the cost of living) can be a solution.
I believe most investors ought to have at least 20% to 40% of their portfolios in assets that can increase in value, such as stock funds. History shows that even a very modest equity stake can noticeably increase the return without any significant additional risk, compared with an all-fixed-income portfolio.
For a more complete discussion of how much risk to take, see an article I wrote last summer.
Nearly every investor at some time or another finds out firsthand how easily emotions — think fear and greed — can get out of hand and start dictating decisions. Greed and fear are the two biggest forces driving Wall Street, and nobody is totally immune to them.
Another form of emotional risk is grandiosity, thinking you know more than you really do and becoming overconfident in your ability to see into the future.
Here’s how this peril often plays out: During a bull market, timid investors who are on the sidelines see others making big gains. These investors eventually get so anxious to get some of those gains for themselves that they jump into whatever is “hot” at the moment.
Conversely, in a bear market, resolute investors see their portfolio values dwindling and eventually sell out – often at a loss.
I call this the “I can’t stand it any more” market timing system. Very often, it leads people to buy near the peak of a market cycle and to sell near the bottom of a cycle.
If investors could follow the old Wall Street saying, “Buy low and sell high,” they would make money. But in both instances, the “I can’t stand it anymore” timing system leads them to do the opposite.
To protect yourself from the risk of grandiosity, be brutally honest about the results of the investments you have made. Keep a list, if necessary, of the decisions you made that went wrong. Next time you are sure that you know better than the rest of the market, pull out your list and study it.
The best protection against emotional risk is a disciplined plan for buying and selling. Make sure your portfolio has enough in bond funds that you can sleep at night no matter what the market is doing. And make sure you have some equities so you won’t feel totally left out during bull markets.
If you master these three aspects of investment risk, you’ll be well on your way to above-average success along with your share of peace of mind. That’s a combination that’s worth striving for.
Want to know more about understanding and managing investment risks? Check out my latest podcast .
Richard Buck contributed to this article.