MBA SERIES (part 1); RISK VERSUS REWARD

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Welcome to encore month at Barbara Friedberg Personal Finance. We are caravanning across the country to our new home in a new land. During this major transition, please enjoy guest articles and some of my best previously published posts.  

This first week of July, check out my MBA series and get some of the same material I taught my Portfolio and Investing students.

a version or this post originally published; May 25, 2010

Risk versus Reward

“When the weather changes, nobody believes the laws of physics have changed. Similarly, I don’t believe that when the stock market goes into terrible gyrations its rules have changed.” Benoit Mandelbrot

This brilliant mathematician speaks to the fact that the price of common stocks goes up and down. Plain and simple, that is where  the risk comes from.

As I have mentioned in a previous article, please follow these steps before beginning an investment program.

Main Topic: What is the relationship between investing return and risk?

Understand the relationship between risk and reward and become a smarter investor. There is an unavoidable trade off between risk and reward. If you desire a higher return on your investment, you must take greater risk.

How it works; a risky investment compensates you with a higher return than a safer investment. If the returns were the same, you would always choose the one with less volatility!

Reward=More money back from your initial investment

Risk=Possibility that your payback won’t be what you expected, but less than you expected.

 NO ONE IS UNHAPPY IF THEY MAKE MORE MONEY ON AN INVESTMENT THAN PLANNED!

So the risk is really that your investment will be worth less in the future than when you started.

How to get a reward from investing?

1.  Buy a financial asset such as a mutual fund which holds common stocks. One of my favorites is Vanguard Total World Stock Index Fund Investor Shares (VTWSX).
2. Receive periodic dividends (cash payments) along the way.
3. Watch your investment increase in value.

How much might I earn?

1. Over the last 80 years, U.S. stocks returned a bit over 9%/year.
2. There is a strong probability that holding this stock mutual fund for 10 years or more would produce a greater return than keeping your money in a savings account.
3. If you invested $1,000 in year 1- received a 7% (a bit more conservative return) return for 20 years, you would have about $3,900.00 at the end of 20 years.

How can I get this terrific return?

1. Open a brokerage account at Vanguard.com or any discount broker.
2. Arrange to have money transferred to the account from your bank account.
3. Purchase a diversified stock index fund (a fund that holds lots of different stocks from a variety of industries).
4. Reinvest the dividends; instruct Vanguard to buy more shares of the fund with the dividends.
5. Wait 10-20 years. Or continue investing every year multiply your returns. 

What is the risk?

1. Stocks, like those in the mutual fund you bought go up and DOWN in price. The risk is almost certain that during those 10-20 years, some years, the value of your investment will go down.
2. There is a possibility that you might have less money than you started if the historical trend of the stock market shifts and becomes negative.
3. Although there is a risk that some years your investment return will be negative, if history is any guide, over the long term, you will earn more money by investing in stocks than if you kept the money in the bank money market account.

How do I decide whether investing in a stock mutual fund is for me?

If you answer YES to these questions, investing in a stock mutual fund may be

right for you:

1. Do you have 6 months of living expenses in cash in a safe savings account?
2. Do you have term life insurance for your dependents?
3. Are you without credit card debt or at least paying it off?
4. Can you leave the money in the stock mutual fund at least 8-10 years?
5. Do you want to earn a greater return than the inflation rate for future goal(s)?
6. Can you sleep at night and not panic if your investment value declines sometimes?

PRACTICAL APPLICATION: Why Take the Risk?

In investing, the greater the potential reward, the greater the risk. Common stocks have the potential to offer high returns in the long term. In the short term their values move up and down so much that it is impossible to predict whether your return will be positive or negative.

If you want a way to finance long term goals such as retirement, home renovations, down payment on a home, and college expenses for your child, then stock mutual funds are an excellent vehicle. However, if you cannot cope with an investment that goes up and DOWN in value, do not invest in common stock mutual funds.

ACTION STEP:

Get a notebook and label it: “(your name) Personal Finance” and keep it by the computer. Use it for all of your personal finance goals, thoughts, activities, and plans.

 If you are interested in investing, and want to read more, check out these resources:

•  
  • Vanguard investing truths
  • Get Rich While you Sleep with the Magic of Compounding
  •  Little Known Investing Secrets: How to Buy Low (Always)
  • ETF Risk at Monevator

 What are your thoughts on investing risks. Have you ever invested more than you could afford to lose?

image credit; O. G. Kraze