(a version of this article was previously published on May 25, 2010)
“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.
I’m teaching a 10 week class in the MBA (Master of Business Administration) program at a local College. I thoroughly enjoy the information I am teaching as well as sharing it with students in the class. In this occasional MBA Series, I’m going to share a distillation of some of the MBA finance concepts. Enjoy!
After reading the article you will gain a useable investing skill.
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.
Reward=More money back from your initial investment
Risk=Possibility that your payback will be less than 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. In fact, if you have invested at all, then you already know that sometimes the value of your investment holdings GO DOWN as well as UP.
How to get a reward from investing?
- 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).
- Receive periodic dividends (cash payments) along the way.
- Watch your investment increase in value.
How much might I earn?
- Over the last 80 years, U.S. stocks returned a bit over 9%/year.
- 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.
- If you invested $1,000 in year 1- received a 7% return (dropped the return 2% from historical returns, for a more conservative approach) for 20 years, you would have about $3,869.68 at the end of 20 years.
What’s the risk?
If you invested the $1,000 at the beginning of 1990, and reinvested the dividends, you would have earned a respectable 8.35% annual return. Not bad!
What if you didn’t start investing until 2000? Not so great! The first decade of 2000 is up there with the worst of all times at a negative .61% return. Now, it’s not all bad. Had you invested regularly throughout the last decade, your return would have been a bit better.
Additionally, don’t forget that we are considering returns from the S & P 500 U.S. stocks. If you had a balanced portfolio of U.S. and international stocks, bonds, and cash, your returns would have been much better.
RISK:
- Stocks, like those in the S & P 500 mutual fund go up and DOWN in price.
- The risk is certain that during those 10-20 years, some years, the value of your investment will go down.
PRACTICAL APPLICATION: 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:
- Do you have 6 months of living expenses in cash in a safe savings account?
- Do you have term life insurance for your dependents?
- Are you without credit card debt?
- Can you leave the money in the stock mutual fund (I prefer index funds) at least 8-10 years?
- Do you want to earn a greater return than the inflation rate for future goal(s)?
- Can you sleep at night and not panic if your investment value declines sometimes?
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.
Caveat: This article is for information purposes only and may not be appropriate for your individual situation.
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:
- 20 Minute Guide to Investing (Fill out the form at the top right of the page. I promise, I won’t spam you with lots of mail!)
- Vanguard investing truths
- Get Rich While you Sleep with the Magic of Compounding
- Little Known Investing Secrets: How to Buy Low (Always)
What are some of your investing wins and losses?
If you like what you’re reading, pick up my RSS feed and follow me on twitter so you get the word immediately.
