Investing Series: Risk vs Reward

Every once in awhile, someone will ask me what they should invest in. I never make specific recommendations, as I never know their full story and each investment decision should be made with the complete picture in mind (money available, goals, time horizons, etc). But I’m usually willing to steer someone towards a type of investment. As part of that conversation, I usually ask about the person’s goals for the investment and their risk tolerance. Inevitably somebody will say that they want to earn as much money as they possibly can…beat the market…beat their friends…but they want to do it with as little risk as they can. None, if possible.

These ideas are inherently at odds with one another. With rewards come risks. With risks, come the potential for higher rewards. If you want to be as safe as possible, you have to be willing to accept lower earnings on your investments. And if you want high earnings, you have to be willing to accept higher risk.

But why is that true? And exactly what levels of risk and reward correspond to one another? That’s what we are discussing today.

Asset Classes and Associated Risks

There are three main asset classes. Cash (includes savings and money market accounts), Bonds (includes bond funds), and Stocks (includes stock funds). Those are listed in order of lowest to highest investment risk, and lowest to highest potential reward (investment returns).

Cash is an inherently safe and stable investment if you look at it in absolute terms. Your dollar amount shouldn’t go down if you have it in cash investments, except of course when you make a withdrawal. However, the relative value can go down if the return on investment is lower than the rate of inflation. This makes cash a good place to park short term money (savings for a car, for instance) or your emergency fund (because you want something reliable and safe). For longer-term investments, such as your retirement account, it’s not such a good idea to have a large percentage in cash unless you are already retired. Or maybe if you are extremely risk averse, in which case you will need to save more money to end up with enough in retirement.

Bonds are more risky than cash, but less risky than stocks. As you’d expect, that means the expected returns for the bond asset class is also in the middle. Keeping bonds in your investment portfolio allows you to diversify, as bonds often – but not always – move differently than stocks. That means that if the stock market is going down, the bond market *may* be going up and vice versa. There’s absolutely no guarantee of that, but it happens.

Stocks are the riskiest investment class, with the highest potential reward. The high potential for reward is what keeps investors in the stock market, despite the very real threat of plummeting prices. Don’t worry too much – that only happens occasionally. Most years, the stock market goes up. But it does go down sometimes, so the risk of losing your money needs to be taken into account.

Just How Different Are The Potential Rewards?

According to this interesting (IMO) data from Vanguard, these are the average returns for each asset class between 1926-2014. Remember, when you are looking at expected returns you want to look at long time spans. Looking at short time spans, say 10 years or less, is unlikely to present useful data as it won’t account for events such as multiple recessions or growth caused by disruptive technologies.

• Cash: 3.5% average annual return before inflation, 0.6% after inflation

• Bonds: 5.5% before inflation, 2.5% after inflation

• Stocks: 10.2% before inflation, 7.1% after inflation

Side Note: today at work some coworkers and I were discussing investments and the subject of likely investment returns came up. I mentioned running calculations at estimated 5%, 7%, and 9% average annual returns. Some of the others scoffed at the thought of a 9% average return. Look at the average for stocks again. I’m not saying it’s likely, or that you should expect it. But it’s certainly a possibility.

(personally, I plan for a 7% average annual return before inflation when planning)

Types of Investment Risk

There are multiple types of risk you’ll face with your money. I already mentioned inflation risk when I talked about cash. Another common risk is volatility risk – prices of investments, and therefore their value, go up and down constantly. The risk comes from the threat of buying when the asset is too expensive, or selling at too low a price.

Liquidity risk is the risk you incur related to timing. Some assets are inherently more liquid, meaning you can access them easier. For instance, cash is a very liquid asset but an investment real estate property is not. Bonds and stocks are more liquid than property, but less liquid than cash. Pulling cash out of savings doesn’t require finding a buyer – you just take it out. Bonds and stocks require you to sell them if you want to liquidate your assets and convert them into cash. If the buyers aren’t paying a price you want, you’ll either have to sell at a lower-than-desired price or accept that you can’t liquidate them at the current time.

Business risk is a risk you incur when you buy a stock or bond. Since a stock is literally partial ownership in the company, you now have a vested interest in seeing that company succeed. And with a bond, you are banking on the ability of the company to pay back their debt. In either case, if the business fails your gamble against risk didn’t pay off.

Bonds and cash also incur interest rate risk. If interest rates change, you may receive less money than you panned to when you sell the bond or cash out the cash account. With a bond, a rising interest rate is actually a bad thing for the bond holder, because new buyers will likely be more interested in newer bonds that are sold with higher interest rates instead of buying your bond with a lower interest rate. You might have to sell the bond at a discount if that happens.

Finally, concentration risk is the risk of holding too much of a single asset, which can end up hurting you an outsized amount if something goes wrong with that asset. Diversification of assets is the way to mitigate this risk. If you are old enough to remember the Enron scandal and bankruptcy of 2000-2001, you’ll know that the problem for many of the employees was that their investments were largely or entirely made up of Enron stock. When the company failed, thousands of employees lost their life savings. Don’t let that happen to you. Diversify your investments!

What Kind Of Risks Should You Be Taking?

I dunno.

What are your goals? Do you want to retire early? Are you willing to keep working if your retirement fund isn’t large enough by the time you reach your desired retirement date?

Does the thought of losing money keep you up at night? If so, you’ll probably want to invest in lower risk investments and commit to saving a higher percentage of your money. Or, just limit the amount of times you look at your account balances. I’ve mentioned this before, but I only add up my balances once each year. I may check a particular account 3-4 times throughout the year if I need to find some particular piece of info, but I’m not staring at rising and falling numbers. That would drive me mad.

You should also be considering your investment time horizon. If you are putting aside money to buy a house in 3 years, generally speaking that money should be put into a lower risk investment than the money for your retirement in 30 years. You don’t have to do it that way – you are allowed to invest the money in any asset class. But generally speaking, the shorter the time horizon the safer the investment type you should choose.

The curve ball is people looking to retire early. In that case, you may want to invest more aggressively, even though you have a shorter time horizon than others your age. The goal there would be to trade the risk of losing money for the reward of retiring early. But that probably needs a whole post for itself.

Are you a low risk investor? High risk? How do you balance these items in your financial plan?