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The Risk Principle of Investment

9 December 2014 No Comment

canstockphoto14131408Risk is inherent in investment. But if you are unwilling to assume a certain level of risk, you will most assuredly lose wealth. This is the reality of buying power as it relates to inflation. As a nation’s currency is inflated, individual dollars are worth less over time. So that $10,000 you have sewed into your mattress won’t get you the same amount of stuff in 10 years that it does today. This is why people invest, to protect and increase the buying power of their hard won dough. But there is always the chance you could lose some, or all, too.

So investors accept certain levels of risk. Every form of investment carries with it a level of risk, but these vary widely from form to form. Some investments pay off very little, but have almost no risk of losing value. Others are more likely to lose value than not, but bear the possibility of bringing in huge winnings. We’ll say that on the one hand you’ve got money sewn into a mattress and on the other hand buying a lottery ticket. I don’t recommend either approach, so an investor needs to make his or her life somewhere in the middle. Here are different degrees of risk found in various forms of investment. The wise investor will create a portfolio that is some combination of all levels of this spectrum.

Risk Level 1: Bonds – The US government has never defaulted on bonds in its history, making them one of the most secure forms of investment around. Because of this, many investors buy up more and more bonds as they age, to make sure that they don’t lose a boatload in a sudden stock market crash, just before or during retirement. Bonds bring in returns at roughly 4% a year. It’s nothing you’ll get rich on, but if you already have money, it’s a great way to preserve its value and even increase it somewhat, without bearing the risk of catastrophic loss. Again though: low risk, low reward.

Risk Level 2: Stocks – The stock market is a tricky game. The closer you zoom in to individual stock behaviors, the harder it is to come out on top. Individual stocks whizz around like mosquitoes. They may have an overall trajectory, but moment by moment, or even year by year, it’s very hard to know what they are going to do. Some stock pickers are great at this, bringing in annual returns in the 10’s and 20’s, or higher, year after year. But these are in the minority. Most active stock managers fail to beat the market, which rises on its own about 9% a year, on average (there are many down years). An index mutual fund latches onto dozens of stocks all over the market to leverage the overall growth of the market.

Risk Level 3: Stocks/Day Trading – This is the way people get rich quick (and the alternative). Remember how I said that stocks jump around a lot? Day traders make short wagers on this behavior, taking home bundles for insight and paying dearly for mistakes. This system has been digitized in the form of spread betting, where investors win based on their correct prediction of stock growth or loss, and the amount the market goes in their chosen direction. Many bets can be made a day, so the potential for growth and loss is enormous.

The savvy investor will accept judicious amounts of each of these risk levels. By putting all your money into level one, you’d never make a thing. All level 2, you’d have to settle for very gradual growth, without any guarantees that it would be there when you most need it. All level 3, and you stand a good chance of losing it all, or will at least have a mercurial existence. Talk to your finance professional about how much risk you should include in your portfolio.

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