Investing basics: Risk versus return
You can’t have one without the other
Risk—just the thought of it can give investors sleepless nights. However, through careful planning for your financial future, you can help manage risk.
Risk is something you encounter everyday. Even crossing a busy street involves some risk. With investments, balancing risk and return can be a tricky operation. All investors want to maximize their return, while minimizing risk. Let’s face it, putting your hard earned dollars on the line can be downright frightening.
Some investments are certainly more “risky” than others, but no investment is risk free. Trying to avoid risk by not investing at all can be the riskiest move of all. That would be like standing at the curb, never setting foot into the street. You’ll never be able to get to your destination if you don’t accept some risk. In investing, just like crossing that street, you carefully consider the situation, accept a comfortable level of risk, and proceed to where you’re going. Risk can never be eliminated, but it can be managed. Let’s take a look at the different types of risk, how different asset categories perform, and the ways and means to help manage risk.
Types of risk
When most people think of “risk” they translate it as loss of principal. However, there are many kinds of risk. Let’s take a look at some of them:
- Capital Risk: Losing your invested monies.
- Inflationary Risk: Investment’s rate of return doesn’t keep pace with inflation rate.
- Interest Rate Risk: A drop in an investment’s interest rate.
- Market Risk: Selling an investment at an unfavorable price.
- Liquidity Risk: Limitations on the availability of funds for a specific period of time.
- Legislative Risk: Changes in tax laws may make certain investments less advantageous.
- Default Risk: The failure of the institution where an investment is made.
How do different assets perform?
It may seem that there are countless types of investment products to choose from but, basically, there are three types of core investments: cash (or cash equivalents), bonds, and stocks.
- Cash: Investments such as bank savings and checking accounts, Certificates of Deposit (CDs), and Treasury Bills. The prices generally don’t fluctuate very much. To investors concerned with loss of capital risk, cash would appear to be the most secure choice, as principal is guaranteed and/or insured. Savings and checking accounts are highly liquid, as they can be readily converted into cash. With CDs, you may face liquidity risk, as they must be held for a predetermined period of time or may be subject to penalties for premature withdrawal. Although risk to principal may be minimal, loss of purchasing power, or inflationary risk, must be taken into consideration. When inflation and taxation are taken into account, returns can be considerably lower. Hypothetically, let’s say in 1981 you earned 14% in an investment. It sounds astronomical; however, the inflation rate at one point that year soared to 15%. That’s a net loss of value of at least 1%—and that’s before taxes take another bite.
The Consumer Price Index (CPI) measures a representative sample of goods and services purchased by American consumers. It is generally considered a primary measure of inflation. T-Bills are represented by the Salomon 1-3 year Treasury Index. It is an unmanaged index generally considered representative of the U.S. short-term bond market. Bonds are represented by the Salomon High Grade Long-Term Corporate Bond Index. It is a bond market indicator comprised of about 800 bonds with maturities of 12 years or more rated AA or AAA. Stocks are represented by S&P 500 Stock Index, a registered trademark of Standard & Poor’s Corp. The Salomon and S&P Indexes are unmanaged and do not include any charges or expenses that you may incur as a direct investor of these securities. Past performance is no indication of future results.
- Bonds: Commonly called “fixed income investments,” they are basically loans or “IOUs.” Interest is earned on the money you lend. The prices of bonds do move up and down, but normally not as much as stocks. Many people think of bonds as conservative investments, but the returns can have a high degree of volatility. The fluctuation of interest rates is called interest rate risk, and a downturn in the bond prices could significantly decrease the overall return of any particular bond.
- Stocks: Represent equity in, or partial ownership of, a company. An easy way to remember the difference between stocks and bonds is: “With stocks, you own. With bonds, you loan.” The price of a stock or share can move up or down, sometimes a lot. The returns of stocks from year to year can be quite volatile, but, as the graph illustrates, the returns from stocks have significantly outpaced inflation, and topped the returns from cash and bonds as well, over this twenty-year period.
Finding your comfort zone
It’s possible to achieve higher returns through stocks rather than bonds, and through bonds rather than through cash, but you can’t expect to get higher returns without taking on some degree of unpredictability. If you seek higher returns, you have to be willing to live with higher risk. “How much risk is right for me?” The answer will affect your investment decisions. Although past performance is not a guarantee of what will happen in the future, historical results over a long period of time can help you make your investment decisions.
The ways to manage risk
There are a number of strategies that can help limit risk while offering the potential of higher returns.
- Diversification: Investing in a variety of investments, or simply following the old adage “Don’t put all your eggs in one basket.” With a portfolio spread among several different investments, you benefit when each type is doing well, and also limit exposure when one or more investment is performing poorly.
- Asset allocation: Building upon the diversification concept, with asset allocation you create a customized portfolio consisting of several asset categories (cash, stocks, bonds) rather than individual securities. Changing economic conditions affect various types of assets differently; consequently, each asset category’s return may partially offset the others’.
- Dollar cost averaging: Systematically investing a fixed dollar amount at regular time intervals. When this disciplined program is adhered to and market fluctuations are ignored, it attempts to “smooth out” the ups and downs of the market over the long haul. Dollar cost averaging, however, cannot guarantee a positive return in a declining market and you must consider your ability to continue investing on a regular basis under all market conditions.
The means to manage risk
Most investors find it difficult to diversify effectively across the full spectrum of cash and individual stocks and bonds. That is why so many investors have chosen variable products to apply the strategies previously mentioned. Mutual funds, variable annuities, variable universal life insurance products offer the potential for maximizing investment performance, investment flexibility, and convenience. They allow you to allocate investments among several asset categories to tailor the mix to suit your needs. In addition they offer professional investment management, and allow you to leave the day-to-day decisions to the “experts.” Of course, like any investment, these products involve risk and you should read a prospectus carefully to see if they are right for you before investing. The returns and principal values of investments in mutual funds, variable annuities and variable life insurance policies will fluctuate. Mutual funds involve investment advisor fees and other fees. Such fees are also involved with variable annuities and variable life insurance as well as insurance-related charges such as mortality and expense risk charges, surrender charges and cost of insurance.
Plant your tree today
An old proverb states, “The best time to plant a tree was yesterday. The second best time to plant a tree is today.” This “power of time” concept applies to personal finance as well. The sooner you implement your investment plan, the greater the wealth you can potentially accumulate. In addition, the longer your time horizon, the easier it is to ride out the ups and downs of your investments. The length of time investors hold onto their portfolios is one of the crucial factors determining the likelihood of obtaining a positive return. Financial history indicates that investors are amply rewarded in the long-term for assuming risk. Regrettably there’s no magic potion for eliminating risk. But by carefully creating a long-term, diversified investment program you can help manage risk. For assistance, contact us to put you together with a NYLIFE Securities Inc. registered representative—professionally trained and experienced—who can help you analyze your needs and assist you in putting together an investment program that fits your needs—at no charge to you.
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