The idea of getting a return on an investment is the cornerstone of saving and investing. With every investment comes some form of risk. As we evaluate our choices for investing, it’s important to think about how reward and risk are related. How much and what kind of risk we can tolerate will determine what kind of assets we will invest in.
The term risk in an investment context covers several very different things.
Risk of Physical Loss
This kind of risk applies to assets that we have in our physical possession, like currency, precious metals, collectibles or real estate. Usually, we protect ourselves against this type of risk through physical safeguards (safes, guard dogs, insurance, etc.). This is not a risk that usually plays a big part in our investment decisions.
Risk of loss of principal
This return on investment applies to assets whose return normally comes mainly from increases in value, not from cash flow. What goes up can also go down. This applies most obviously to common stocks and commodities, but also affects precious metals and real estate. To a smaller degree it affects preferred stocks and bonds. In general, it is the case that all assets that have the capacity to produce a large gain in any given year, also have the capacity to produce a large loss.
Stocks have been one of the two engines of long-term wealth-building (real estate being the other). Over the long term, the stock market has, on average, had a return on investment of returned around 10% (large caps) to 12% (small caps) per year, including price change and dividends.
But individual rolling twelve-month return on investment in the stock market have rarely been anywhere near the average. Twelve-month returns have ranged from a loss of 63% (12 months ending June 30, 1932) to a gain of +135% (12 months ending June 30, 1933), both including dividends. Even if you want to throw out the great crash and depression as outliers, we are still left with many very large swings. There were quite a few years whose returns were worse than -20%, some as bad as -40%; and also, quite a few that were better than +40%.
The point is, the long-term average stock market return of 10-12% doesn’t happen every year; in fact, it rarely happens in any year. It is only over long time periods that the long-term averages assert themselves. In any one year, literally anything can happen in the stock market. And no one rings a bell at the top. The same is true of other volatile markets including real estate and precious metals. If we happen to be very unlucky and push in all our chips just before a big crash, then from our point of view the average rate of return on the stock market could be a big loss.
Risk of loss of purchasing power
This one is not as obvious as the others. Nevertheless, it is a real risk. If you put a hundred-dollar bill in your wallet and leave it there for five years, it will still be a hundred-dollar bill when you spend it. However, it will not buy as much as it would have when you put it away. If inflation over that five-year period was at a typical 2.9% annual rate, that hundred dollars will only buy 86.7% of what it would have originally. You have lost over 13% of your original purchasing power, even though you still have the same number of dollars.
Although this risk can be seen most clearly when we think about cash, it also applies to any investment whose return is near or below the rate of inflation. This is most likely to be true of safe assets whose return is mainly in the form of cash flow, meaning dividends and interest rather than capital gains.
This risk of loss of purchasing power is what we run into when we attempt to guard against risk of loss of principal. You could say that inflation is a tax on caution. If your savings/investments don’t earn enough to maintain purchasing power after inflation, then they are not making enough to earn their keep.
So where does that leave us? Putting everything in the stock market would give us too much risk of losing principal. Avoiding that risk by leaving all of our money in the bank, on the other hand, gives us too much risk of losing our purchasing power to inflation. Using other assets gives us varying degrees of both these risks. Attempting to avoid the problem by hiring someone else to manage our money may just compound it because of their fees.
Selecting investments to diversify risks and managing them to reduce risks
You have no doubt heard that wealthy people get and/or stay that way by cultivating multiple streams of income. This is really another way of saying that wealthy people diversify their risks. If an investor has cash flow from some combination of businesses, bank interest, bond interest, preferred stock dividends, real estate rents and other sources, then they can weather occasional periods when their stock market investments or real estate lose value. There is no need to fear the bear markets if other investments take up the slack in those times. Diversification itself reduces overall risk and helps to ensure you will have a positive return on investment.
But we can do better than that. If we can also at least partly avoid the loss of value in the bear markets for our volatile, money-making assets, then we would be hitting the sweet spot.
That is what our Proactive Investing model is designed to do. In a very brief nutshell, the approach is to select a diversified group of assets, so that we have cash flow coming in at all times; and then to manage each of those assets individually so as to minimize its individual risk. It sounds simple, and it is, once the details have been laid out. If you’d like to know more, contact your local center.
Read the original article here - Return on Investment and Risk