Understanding Risk, Reward & Other Investing Basics

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The Truth About Risk

Before we delve in, let’s deal with the scarlet ‘R’: Risk. When it comes to money, it’s a word we either associate with loss and destitution, or reward. Here’s what it means in investment terms:

An asset is considered “aggressive” or “risky” because it’s been prone to wild price fluctuations in the past.

Now, there’s no guarantee of how it will perform in the future. But when it comes to investing the future is never guaranteed. So, if you plan on developing an investment portfolio of any sort, you’re going to have to assume and accept some measure of risk – be it massive or miniscule.

What kind of risk are we talking?

All sorts. To name a few:

  • Market risk: the possibility that an investment will lose value because of a general decline in financial markets
  • Inflation risk: also known as “purchasing power risk”, meaning the possibility that prices will increase in the economy as a whole, hence the ability to purchase needs or services with proceeds from that asset will decrease
  • Interest rate risk: subtle or sudden fluctuations in prevailing interest rates that can lead to instability of investments like bonds
  • Reinvestment rate risk: when funds are reinvested at a lower rate of return than the original investment
  • Liquidity risk: how quickly and easily you can convert your investments to cash
  • Political risk: the possibility that new legislation or changes in foreign governments (if you invest in foreign markets) will undermine the performance of your investments

Is there an equation between risk and reward?

If you’re a numbers person, you can use the Rule of 72 to judge an investment's potential. Here’s how it works:

  1. Divide the projected return into 72
  2. That answer is the number of years it will take for the investment to double in value
  3. For example, an investment earning 8% per year has the potential of doubling within nine years

Note the word: ‘potential’ (the optimist’s word for ‘risk’).

Here’s something else to think about. At 25, 30, even 35 years old, you’re gifted with the luxury of time. Because time is on your side, you can tolerate greater risk…financially speaking. It’s up to you to decide how much risk you can handle psychologically.

Bottom line: The more risk you’re willing to take on now, the higher your potential returns (or losses) could be down the line.

Let’s Talk Reward

Enough about risk! Let’s grab the financial bull by the horns. While it’s up to you and your financial advisor to develop a portfolio that’s right for you, here are five golden rules to invest by.

Rule #1: Transition from a savings à investment plan

The first step in any investment plan is paying yourself first, that means funding your baseline savings before you dabble in anything further. No exception. This will…

  • Get you in the habit of saving
  • Let you dip your toe in the market before you dive in (without your floaties)
  • Give you some time to set your long and short-term investment goals

Rule #2: (Invest)igate fully

Before you part with your money, invest your time in the three Rs:

  1. Reading: Spend some time reading financial websites for the most up-to-date dos and don’ts on investing and market trends.
  2. Researching: Your findings will determine your investment strategy. Always invest with your head, not your heart or your gut (unless it tells you an investment rate is too high to be true, because it probably is).
  3. Resources: Take advantage of those available to you, especially a company’s prospectus. Also, call your state securities regulator for a background check before doing business with a third-party investor.

Rule #3: Dabble when you’re ready

Comfortable yet? Good. It’s time for you to start an on-line brokerage account. Continue building your wealth (of knowledge!) and put your money into index funds—index funds attempt to duplicate a standardized, broad-based index such as the Standard & Poor's 500 stock index or Moody's bond index by holding a portfolio of the same securities used by the index in an attempt to match the index's performance as closely as possible. The aim is to keep costs down and diversification up.

Rule #4: Don’t obsess

What goes up must come down. The same principle applies to the stock market. Both booms and downturns can last for many months or more. Your best bet is to adopt a “buy and hold” attitude and invest for the long haul. Try not to check your account every day, but if you do, resist the urge to sell on a down day.

Rule #5: Compounding works in your interest

If you start investing $5 a week at an investment return of 8% when you’re 18 years old, by age 65 you could end up with a total of $134,000. If you start at 40, you’ll have to set aside $32 a week to reach the same sum. That’s the miracle of compound interest.

Bottom line: Losses happen, as do glorious gains

To end up on the right side of the coin, educate yourself and keep your portfolio diversified.