The Greatly Misunderstood Risks of Investing
publication date: Aug 12, 2010
In my prior work as a financial counselor and teaching adult education classes, when it came to investing, I repeatedly saw vast misunderstandings and gaps in knowledge when it came to understanding investing risks. Most people understood risks which were easy and simple to observe such as the risk of stock prices dropping sharply in a short period of time or the stability of your investment dollars in a short-term bank CD or government Treasury bill.
But people inevitably overlooked less obvious risks, especially those which played out over longer periods of time. More on this in a moment.
The severe stock market decline that ended in 2009 and the increasing chorus on pundits being interviewed in the media or blogging online has made the situation even worse in my view. I find more people paralyzed and fearful now and looking for a system to beat the system.
You turn on cable television and flip channels and you'll hear "experts" talking about the faltering economy, rising gold prices, faltering U.S. dollar, bankrupt governments, which stocks to buy now and sell now, etc. Online blogs are just as problematic with endless discussions about jumping into and out of various investments and other market timing moves.
Getting Back to Basics
Some in the media and blogosphere are simply preying on people's fears and engaging in trickery to create an illusion that they know the right times to jump into and out of specific investments. Most such folks are small time, active money managers who are hustling to build their businesses.
Risks can be worrisome. But, do you think about all the bad things that could happen to you every time you get into your car? And, simply worrying doesn't accomplish anything except to raise your blood pressure and cause people to stay in their homes to avoid perceived risks.
By understanding risks and how to minimize them, you can become a better investor and have more peace of mind. So, let's start with some basics about investing and then we'll talk about risks.
An investment is something you put your money into, in the hopes of collecting or withdrawing more in the future. All money, therefore, is in some sort of investment, even what's put in "parking places" such as bank accounts or money market funds.
Sometimes people make the mistake of feeling as if their money is wasting away or not "invested" if it's in a parking place. (I noticed far more people thinking that in the late 1990s after many years of strong stock market returns.) They may rush to invest the money elsewhere with the hope of earning a higher return. Later, they may find that these seemingly more attractive investments were also riskier. The risk is that the investment can and sometimes does decline in value. Some investments are riskier, or more volatile, in value.
There's nothing wrong with taking risk. In fact, an investor needs to accept risk in order to have the potential for earning a higher return. However, with some money, you should try to protect and take little or no risk with it. For example, your "emergency reserve" money should not be in an investment subject to fluctuations in value. This money should be "parked" someplace secure and accessible.
There's also a risk in not taking enough risk. Consider investing for retirement. In order to be able to retire, you'll need a certain amount of money saved. If the money you're accumulating is invested too conservatively and grows too slowly, you will need to work more years before you can afford retirement. So, in addition to understanding the different investments available, you also need to select those investments that meet your particular needs.
Comparing Investment Risks
It is helpful to discuss the major dimensions on which investments differ from one another. First, investments may produce current income, typically in the form of interest or dividends (which are paid out profits to corporate stockholders). If, for example, you place your money in a bank certificate of deposit that matures in one year, the bank might pay, 0.75 percent interest. Likewise, if you invest in a treasury note issued by the federal government, which matures in ten years, you may be paid, say, 2.7 percent interest.
Other types of investments, in contrast, may be more growth oriented and not pay much, if any, current income. A growth investment is one that has good potential to increase in value in the future.
Investments that are more growth oriented, such as real estate or stocks (investments in companies), allow you to share in the success of a specific company or local economy in general. The yield on a good stock from its dividend typically is well below the interest rate paid on a decent corporate bond but some stocks do offer decent dividend yields.
Income oriented investments, on the other hand, such as treasury bills, don't allow you to profit when the company or organization profits. When you lend your money to an organization, such as by purchasing bonds, the best that can happen is that the organization will repay your principal with interest.
Some other dimensions on which investments differ from one another include:
- Exposure to inflation. Some investments are more resistant to increases in the cost of living. For example, the purchasing power of money invested in bonds that pay a fixed rate of interest, can be eroded by a rise in inflation. By contrast, the value of investments such as real estate and precious metals, such as gold and silver, often benefit from higher inflation. Especially when investing for longer periods of time, it's important to diversify your investments to include those that are inflation resistant.
- Taxability. Apart from investments in tax-sheltered retirement accounts, the interest or dividends produced by investments are generally taxable. The profits (known as capital gains) from selling an investment at a higher price than it was purchased for are also taxable.
- Sensitivity to currency and local economic issues. Not all investments move in concert with the health and performance of the U.S. economy. Investments in overseas securities allow you to participate directly in economic growth internationally as well as diversify against the risk of economic problems in the U.S. International securities are susceptible, however, to currency value fluctuations relative to the U.S. dollar. Because foreign economies and currency values don't always move in tandem with ours, investing overseas helps to dampen the overall volatility of your portfolio. Investing in U.S. companies that operate worldwide serves a similar purpose.
You can't control risks or eliminate them but a number of sensible steps can greatly reduce them. That's why I have long advocated investing in a diversified portfolio of stocks worldwide (along with real estate and small business for long-term growth potential) and some bonds, the portion of which depends upon your station in life and desire to accept shorter-term risk. Use the best professional money managers and index funds. I have favored value oriented stocks as well because they tend to be less volatile and produce higher long-term returns thanks in part to their higher dividend yields and better valuation.
You should also be mindful of your financial information diet. Just as with food, more isn't better and quality matters more than quantity. By all means, listen to folks who don't agree with one another but be wary of hyped, extreme predictions (see the Guru Watch section for many examples) and those with a financial agenda in their recommendations. Be especially wary of those managing money whose implicit message is that they actively trade and their crystal ball enables them to beat the best money managers.