In The Fight
What would you like your money to do? Come on, tell the truth--wouldn't you like to earn a very high return in a short period of time, 100 percent guaranteed? For some people, investing is like being in a center-ring fight: They want to score a quick knockout punch. Like the boxer who trains only for the big fight, however, there's a very good chance that without proper coaching, you'll come up short. On the other hand, when Rocky fought hard against all odds, the crowds went wild. After all, the fight doesn't always go to the strong or the race to the quick--sometimes it's the tortoise that beats the hare. For every lucky winner, though, there are hundreds of disheartened souls mourning their hero's trip to the mat. When it comes to investing, the difference between winning and losing is about more than just luck--it includes an investor's willingness to assume risk.
What is risk? Risk is uncertainty, and in uncertainty can be opportunity. Without uncertainty, there's little chance for profit. But without some certainty, all you have is risk, and that's like entering a title bout without your boxing gloves. Although risk means different things to different people, how you deal with it can affect your ability to finance your children's education, buy the house of your dreams or retire comfortably. For most investors, understanding risk is as difficult as beating Mike Tyson would be for someone whose only boxing experience is watching "Raging Bull." Understanding your relationship to risk can help you maximize your returns, minimize your losses and reach your financial goals.
There are as many kinds of risk as there are punches. To some, risk is the chance of losing all or part of an investment. A choice between one investment that offers a return of 5 percent and another that offers 10 percent seems easy: Take the one that makes the most. The problems begin when risk pokes its head in and warns you that to achieve the higher return, all or part of the original investment could be lost.
But investing isn't a fight between two opposing champions. That's because smart investors diversify their holdings to decrease the chance of loss and increase their opportunity to make money. As you can imagine, investments with a very low risk factor probably won't make you rich. When you consider how the wealthy got that way, you'll probably find it's through real estate, business ventures, stock portfolios or even inheritances--but rarely is it through investing in CDs and T-bills. On the other hand, if you place some of your assets in secure investments, you probably won't get stuck with a black eye and nothing to show for it. Experts agree the best strategy may be to diversify your assets between high-, moderate- and low-risk investments to take advantage of all opportunities, much like the fan who wants to get ringside seats to a good fight, whether it means attending heavyweight, welterweight or bantamweight bouts.
Lorayne Fiorillo is a financial advisor and first vice president of investments at Prudential Securities Inc. Past performance is no guarantee of future returns. For more information, write to Lorayne in care of Entrepreneur, 2392 Morse Ave., Irvine, CA 92614.
Are You Up Or Down?
Another aspect of risk is volatility. Anyone who's invested in equities and witnessed the undulating nature of the stock market knows that some share prices move more wildly than others. Consider hypothetical utility stock ABC, for example. Its price has fluctuated between $25 and $35 this year. On the other hand, the price of technology stock XYZ has moved between $10 and $50. Stock XYZ's value moves about five times as much and is thus roughly five times more volatile than stock ABC. Some investors conclude that stock XYZ is more risky than ABC because its price fluctuates more.
Should fluctuations make you scratch an investment from your portfolio? Not if you're a long-term investor. If your goals are at least three to five years away, don't let the daily, monthly or even quarterly vicissitudes of your investments sway you. Instead, consider investing in more than one stock in more than one mutual fund with more than one investment advisor. Risk can be controlled by placing funds in investments that don't move in tandem.
Looking for ways to enhance the return on your portfolio? In addition to a broad range of individual investments, consider dividing your funds among different asset classes, including stocks, bonds, cash and real estate. In his book Get Rich Slowly (Macmillan Publishing Co.), William T. Spitz, treasurer of Vanderbilt University in Nashville, Tennessee, notes that over the 20-year period from the beginning of 1971 to the end of 1990, the annual return of stocks, as measured by the S&P 500, averaged 11.1 percent, with two years of fairly substantial losses, 1973 (14.8 percent) and 1974 (26.4 percent). If all your assets had been in the running in the stock market, your 10 percent average annual payoff would have been achieved, but with a fairly bumpy ride. After all, while stocks offer long-term growth potential, they may not generate the present income other investments do. Had you instead divided your investments in thirds, placing equal amounts in stocks, bonds and real estate and then rebalanced annually to keep the investment percentages the same, your return for the same 20-year period would have been 10.3 percent--a much smoother ride.
Is there such a thing as a risk-free investment? "Not on this planet," says Daniel Taylor, managing partner of The Taylor Group, an asset management and consulting firm in Charlotte, North Carolina. "Some things are just riskier than others."
Be wary of investments that promise high returns with little or no risk. Even investments that seem risk-free carry the chance that if they're sold before maturity, you could receive less than originally invested. Investments guaranteed by government agencies or ranked high by rating services may ensure that once purchased, your principal isn't going anywhere. That's the good news . . . and the bad news. Stable, secure investments are great for those seeking income or for those saving for short-term goals like buying a house or saving for a car. If you're investing for the long term, however, these investments may not allow your money to keep up with inflation or may be worth less than you paid if you sell them before they come due.
Remember to take into account the effect of inflation on an investment's return. Say an investment yields 6 percent. Factor in an inflation rate of 4 percent, and the yield is down to 2 percent. If you figure in taxes on the money earned, in the 28 percent bracket, lop off 1.7 percent more. Suddenly, your portfolio is no longer a contender. But what's even more risky, Taylor says, "is not being there, not participating, not diversifying to minimize the possibility of losing big, and sitting on the sidelines waiting for a better opportunity."
Fight To The Finish
So how much risk do you have to take to reach your goals? If your goals are moderate and far away and you sock away a good deal of money, it may be possible to attain them with a low level of risk. On the other hand, if your goals are ambitious, near in the future and you prefer to spend rather than save, you'd better be prepared to take more risk or change your evil ways. It all depends on your temperament, financial circumstances and age. Many advisors offer these general guidelines:
- Investors in their twenties are often just getting started, and while income may be good, outgo is usually more. Paying off education loans, saving for a house and starting a family are all expensive propositions that often take priority over saving for the future. Ironically, this is often the best time to sock away money, allowing the effects of compounding to work for you over time. If you can withstand the ups and downs of more volatile investments, consider taking some higher risks with part of your long-term savings. Don't have any money to invest? Start brown bagging your lunch, and earmark the savings for your retirement.
- Investors in their thirties are usually more financially set but are still on an upward track to their peak earnings years. Often saddled with the needs of a growing family, moderate-risk investments are usually the most popular among this age group.
- In their peak earnings years, the forties and fifties, investors often have more disposable income and fewer obligations. Many families have finished paying for their children's college educations (or passed the remaining costs on with the sheepskin) and are now faced with saving for retirement. At this point, the mantra becomes "investor know thyself." If you've never ventured into anything but shares of the local utility and can't stomach the slightest fluctuation, don't put your peace of mind at risk (to say nothing of your money) by taking big chances now with your hard-earned dollars.
Thankfully, you don't have to be Jake La Motta or Muhammad Ali to win big in the investing ring. Just a little common sense, diversification and asset allocation should keep you in the fight.
For reprints and licensing questions, click here.