Understanding Investment Risk
by Gary Foreman
"George said the broker claimed he could get better than a 25% return on the investment. Said it was just like money in the bank." John grinned as he told Mary the story. Earlier that day a co- worker had asked John's opinion of this "once-in-a-lifetime opportunity."
"Did he really believe that?" Mary had met George and was surprised he didn't know better. John added some sugar to his coffee. "It was kind of funny," he said. "He wanted to believe it was possible and yet part of him knew better. We were at lunch and had some time to talk. The conversation got around to different investment risks and how they worked. Turns out that Bill was a broker once so he was pretty up on the subject. He said that every investment had some risk. Even things that we think are safe, like a savings account, can lose value."
Thinking back on an adult ed class she had taken, Mary knew just what Bill meant. "Sure. I remember reading something from the American Association of Individual Investors that said there were four types of risk. There are liquidity, inflation, market and business risks. Bill's referring to inflation risk. You get the dollar you put in the bank back, but it doesn't buy as much anymore. That's called inflation risk. We were shown a table from the Federal Reserve Board. According to the table, inflation has averaged about 3.5% this century. But the high was 18% in 1918."
"That makes sense." John thought back to the late 1970s, when everyone took money out of banks because the inflation rate was higher than the interest rates. "The worst thing about that is there's no place to hide. No matter where you put your savings you'll face some risk. Bill also talked about liquidity risk."
"Oh, I remember liquidity," said Mary. "That's the ability to turn your investment into cash quickly. For instance, a dollar in your wallet is very liquid. A sports collectable isn't very liquid. You could have trouble turning a Willie Mays autographed ball into cash quickly at a fair price." Mary remembered the examples from her class.
"What Bill didn't say was that all your investments don't need to be that available. Once you have some savings for emergencies available, some of your investments can be illiquid. In fact, you'll get a higher return just because you're willing to take the risk that it won't be available." John was thinking of some stock that he and Mary owned. It was a young company that was putting profits back into expansion. But the long-term outlook for the company was excellent. They bought shares with the plan of holding them for a minimum of a few years.
Mary often thought that she would have enjoyed working in financial services. Investments had always fascinated her. "So did you guys get into market risk? As I recall, that's the risk that the whole market will go down. No matter how well your particular company is doing, it's hard for that stock to go up if most stocks are heading down."
"Yes, we even talked a little about how bonds can be effected by a type of market risk if interest rates go up. No matter how well the company that issued the bonds is doing, when interest rates go up the value of your bonds will decrease if you need to sell them before they mature." Again John thought of the late 70s, when people owned bonds that were paying 6% interest while other newer bonds paid 10% or better.
"The other thing that struck me is that some of the younger guys think that the stock market goes up every year. They don't seem to understand that it will go down someday." John considered how every generation's view is colored by their experience. His parents were very aware of market risk. After all, they had grown up during the Depression. The Smiths had gotten married in the 70s and were always concerned with inflation. Those coming of age in the 90s have very little fear of either.
John went on. "What everyone seemed to understand was business risk. Just about everyone had worked at a company that's been through 'downsizing'. Harry had worked for one that went bankrupt. What's interesting is that although everyone's been around companies in trouble, we all seem to forget about that when we think of investments. The way the market's been going, everyone seems to think that their stock won't get into trouble."
Mary had noticed that, too. "So you guys pretty well covered all the risks? Did you get into how to minimize them?" She could read John's expression and tell that the lunch conversation hadn't gotten that far.
"The class I took taught us to use risk to our advantage. First, you need to recognize that there's no investment that avoids all risk. Even relatively safe, guaranteed things like bank accounts can be affected by inflation. So the trick is to balance the risks against each other while getting the highest return in each risk category.
"For instance, I remember them saying that beginning in about 1940 the stock market averaged 13% annually over a 50-year period. Some years were up and some were down. For instance, the market lost more than 11% in 1931. You wouldn't have wanted to sell at the end of 1931, but for some of your money it's better than the 4 or 5% you'll earn in a savings account.
"A similar thing happens with bonds. They're subject to inflation risk. But if you also own some stocks, they tend to go up when bonds go down in value. What you're trying to do is to use one risk to offset another. That's why diversification is so important. By owning different types of investments, one kind will act as insurance against others."
John was glad that they had taken a more reasoned approach to savings and investments. They learned early on that it wasn't impossible to manage their money. It just took a little common sense and study.
"So what do you think, hon? Should I tell George that we'll join him in that investment?" John couldn't help but tease his bride. He was also surprised at how much those little sugar packets could sting when Mary hit him with one!
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Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money and CreditCards.com. Gary shares his philosophy of money here. You can follow Gary on Twitter or visit Gary Foreman on Google+. Gary is also available for audio, video or print interviews. For more info see his media page.
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