Five Keys to Investing Success: Don't Take Unnecessary Risks
Get on the path to your financial goals -- long-term and near-term -- by tapping into Kiplinger's core investment advice.
By the Editors of Kiplinger's Personal Finance Magazine
November 6, 2006
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Editor's note: This is the third part of a five-part series developed from Kiplinger's most tried-and-true principles. It has helped thousands to reach enduring financial success.
Key #3: Don't Take Unneccesary Risks
Most people would say that risk is the chance you take that you’ll lose all or part of the money you put into an investment. That’s true as far as it goes, but it doesn’t go far enough. A more complete definition of risk acknowledges the availability of investments carrying virtually ironclad guarantees that you will get all your money back plus the interest promised you: Treasury securities or certificates of deposit in federally insured banks, savings and loans, or credit unions, for instance. Also, with all investments, even government-guaranteed ones, you run the additional risk that your return will be less than the inflation rate. In fact, savings accounts, certificates of deposit, Treasury bills, savings bonds and a handful of other government-backed investments establish a useful benchmark for measuring risk: Risk is the chance you take that you will lose your money or that you will earn less from your investment than the rate of inflation or less than the interest available at the time from insured savings certificates or U.S. Treasury–backed obligations.
To put it another way, risk is the chance that you will earn less than 3% to 4% on your money. If you can’t reasonably expect to do better than that for the risk you’re taking, then there’s no sense in taking the risk.
How Can You Control Your Risks? The pyramid is a useful visual image for a sensible risk-reducing strategy. It’s built on a broad, solid base of financial security: a home; money in insured savings accounts or certificates; plus insurance policies to cover expenses if something happens. As you move up from the base, the levels get narrower, representing the space in your portfolio is available for investments that involve risk. The greater the risk, the higher up the pyramid it goes and, the less money you should put into it.
How much should you have in savings? Three to six months’ living expenses should be your goal. Bank, savings and loan, or credit union accounts are good places to keep this money, but look for opportunities to earn more than the .25% to 1% interest these institutions tend to pay on their run-of-the-mill deposit accounts—by putting most of it in certificates of deposit, for example. You might use a money-market fund for at least part of this rainy-day money. Such funds aren’t federally insured, but they are conservative places to invest and they often pay a higher return than savings accounts.
Once you’ve built the base of your pyramid, you’re ready to move up and become an investor. One level up is the appropriate place for mutual funds that invest in low-risk, dividend-oriented stocks and top-quality government and corporate bonds. Individual stocks and bonds that you pick yourself are on the same level. Most financial experts would put investment real estate on the next level up. At the very top of the pyramid go investments that few people should try, such as penny or microcap stocks, commodity futures contracts and most limited partnerships.
How Much Risk Should You Take?
Controlling risk means more than being “comfortable” with an investment. Too many investors seem perfectly comfortable with too much risk. The basic thing to remember about risk is that it increases as the potential return increases. Essentially the bigger the risk, the bigger the potential payoff. (Don’t forget those last two words; there are no guarantees.) That might sound exciting, but turn it around: the bigger the potential payoff, the bigger the risk of losing.
Does this mean you should avoid all high-risk investments? No. It means you should confine them to the top of the pyramid—where they can never occupy a significant portion of your investment portfolio. Invest only as much as you can afford to lose because you might in fact lose it. You should also learn to recognize the risks involved in every kind of investment.
Risks in Stocks
A company’s stock could decline because the company’s revenue declines or isn’t being managed well. Or a well-managed and prosperous company’s stock could fall because investors sell millions of shares of stock of all kinds or stocks of a certain kind. That’s what happened when the dot-com bubble burst and it drove the entire market down, without bothering to differentiate the good stocks from the bad.
Risks in bonds
Bond prices move in the direction opposite to that of interest rates, rising when rates fall and vice versa. But individual bond issues can be hurt even if rates in general are falling. For example, one of the rating services downgrades its opinion of the company’s stability. A bond issue that’s paying an interest rate noticeably higher than that of other bonds with similar maturity dates is probably being forced to pay more to compensate investors for the higher risk inherent in a lower safety rating.
Risks Everywhere
Real estate values go up and down in sync with supply and demand in local markets, regardless of the health of the national economy. Gold and silver, which are supposed to be stores of value in inflationary times, have been decidedly unrewarding in times of tolerable inflation. Even federally insured savings accounts carry risks—that their low interest rate won’t be enough to protect the value of your money from the combined effect of inflation and taxes.
What is a prudent risk?
It depends on your goals, your age, your income and other resources, and your current and future financial obligations. A young single person who expects his or her pay to rise steadily over the years and who has few family responsibilities can afford to take more chances than, say, a couple approaching retirement age. The young person has time to recover from market reversals; the older couple may not.
