Most of us have heard the phrases “risk and return” or “risk versus reward”, but have you ever really thought about what it means? It’s a straightforward concept, but super important to understand before investing. In general, the more risk you are willing to take, the more return you can POTENTIALLY make. Keyword: potentially. There comes a point where the risk you are taking isn’t worth the odds. For example, going all in on red at the roulette table within the first twenty minutes of being in Vegas. Slow down. Or going on a blind date with a guy your friend tells you is “super nice”. We all know what that means. And then there’s the risk that’s totally worth the reward: Something so gratifying and personally rewarding that involves little risk, like climbing this rock to get this great shot and the memory of a lifetime for example:
What you should do first, is decide how much ups and downs in the market (also known as volatility) you are comfortable with seeing, how much time you have to recover from loss (your investment time horizon), and how your investments have performed historically (which truthfully speaking doesn’t actually have any bearing on future performance, but it’s nice to know the companies you are putting your money into have a good track record). With help from your advisor, you can then use this information to choose funds, stocks, or an asset-allocation model that fit your agenda.
Modern Portfolio Theory is a fundamental guideline for determining how much risk an investor should take. In order to keep this post simple, we will avoid going into too much detail. However, you should understand that just because you are taking on more risk, it doesn’t necessarily mean you will see more gains and bigger returns. But keep in mind, if you are looking for safety of principal (United States government backed bonds for example), you should expect low returns. A balanced portfolio might contain a variety of investments and cash to ensure that even if the stock market performs poorly for a given period of time or performs poorly in one sector, you will have some money that is not negatively affected. It’s always good to have a cash reserve in the bank that you can quickly access should you need it for something like a medical bill or loss of job.
Younger people with a goal of saving for retirement might be able to withstand more risk due to their longer time horizon. Meanwhile, individuals approaching retirement in several years or less might want to be more cautious; they have less time to make up for losses they may experience during a down-market.
There are a lot of variables that come into play here. Speak with your advisor and be honest about your willingness to withstand loss. Tell him or her when you plan on using the money. If you want to buy a house in two years, you should probably stay away from investing the money you want to use for a down payment. If the market tanks the month before you close, you’re screwed (because of timing). If the money will be used for retirement 30 years down the road, that’s a different story. Just like your doctor, Financial Advisors should look out for your best interest, but it’s up to you to tell them what they need to know and it’s on you to implement their suggestions. We all know we tell fibs to the doctor like “I only have a glass of wine once a week” when really you’re throwing back a bottle of pinot noir every night while binge watching Netflix. The more we know about your finances, the better choices you (and we) can make. Fortunately though, we don’t care how much wine you drink.