Is That Hot Investment Worth the Risk?
High returns are great, but they come with some nasty baggage: high risk. The key is determining whether the reward justifies the risk.
Recently, we talked about how many folks are riding the wave of day trading activity that’s been encouraged by a climbing stock market.
Day trading was trendy decades ago and popular again today, helped along by apps like Robinhood. Many people feel it’s an easy way to make money and earn a return on your investments; many others who are out of work due to the pandemic feel it’s a viable way to earn an income while unemployed.
But despite what news articles (or your friends and co-workers) may say about this investing style, the fact is it’s extremely unsustainable. Investing in single stock positions introduces you to a much higher level of risk than you may truly be comfortable with.
The returns might look flashy, and if you’re not currently buying stocks, you may feel like you’re missing out. What you really might be missing, however, is an understanding of the kind of risk that comes with the promise of big rewards.
You Can’t Talk About Returns without Considering Risks
It’s easy to dismiss conversations about severe risk as overanxious hand-wringing from super-conservative investors when we continually see the same companies becoming exponentially more valuable; think Amazon, Netflix, Facebook and Apple, to name but a few.
It seems impossible that these companies — and their stock prices — could ever fall through the floor. It feels inevitable that they’ll only continue to increase in value, and therefore, provide investors with more profit.
But consider this: To justify its current market price, Tesla would need to have about one-third of the entire global marketplace for luxury cars in 10 years. In other words, it would need to sell a little more than one in three luxury cars sold in the entire world to generate the kind of revenue that its stock price says it should have.
This is just one, tiny example that should serve as a red flag — a crack in the idea that these companies will obviously and continuously increase in value.
Even if you can come up with a great bull market case for Tesla (or any other hot company right now), the fact remains that you can’t talk about massive returns without also talking about outsized risks.
Understanding the Risk You Take with Your Investments
Let’s be clear here: Risk is not an inherently bad thing! We need risk in order to get a return. One of the principles of investing is the risk-return trade-off, where a greater degree of risk is supposed to be compensated by a higher expected return.
If we take no risks with our investments — say, keeping all your money in cash — there is no opportunity for return. You can see that right now by looking at the interest rates offered on even high-yield savings accounts or longer-term CDs. It’s close to zero.
Factor inflation into that equation and you’re actually losing money if you keep it in cash.
Smart investors know that risk is important, but not all risk is created equal. To invest strategically, you must understand, identify and take calculated risks. This means taking the least amount of risk that you need to gain the maximum amount of return you require to meet your goals. And there are very, very big differences in the risk profiles of someone who:
- Invests in a diversified portfolio that holds a big basket of various stocks from across the financial market.
- Puts all of their money into a single stock that they hope skyrockets in value in a short period of time.
In the first case, you are taking a calculated risk because you’re using a diversified portfolio. That diversification is a way of mitigating some of the risks inherent with investing. But a single-stock position is more akin to putting your money on black at the roulette table.
It’s a high-risk activity because you get one shot to get it right. And if you’re wrong? You lose it all.
Is that really something you can afford to do with your nest egg?
Investors Need to Ask Themselves This One Question
The next time someone tells you they earned a 50% return on a single stock, ask them how much risk they took. Was the added gain worth the extra risk?
It’s easy to say “yes” when you beat the house and take home some winnings. But unless you can actually afford to lose everything, the answer should always be no. That extra — and unnecessary — risk doesn’t make sense for most people.
Unless you’re independently wealthy or are expecting a big family trust to take care of you later in life, you have your financial goals that you need to fund. You have your kids’ college education to pay for. You have your own retirement to enjoy.
I’m not going to pretend that picking a single stock and holding a concentrated position isn’t exciting — it can be downright thrilling when you actually guess correctly and get a return for your investment.
But exciting is not the same thing as wise, strategic or financially responsible. Although not nearly as sexy, choosing to be a long-term investor with a low-cost, diversified portfolio will likely provide the return you need to meet your goals while also keeping you safe from risks you don’t need to take.
About the Author
Founder, Lake Road Advisors, LLC
Paul Sydlansky, founder of Lake Road Advisors LLC, has worked in the financial services industry for over 20 years. Prior to founding Lake Road Advisors, Paul worked as relationship manager for a Registered Investment Adviser. Previously, Paul worked at Morgan Stanley in New York City for 13 years. Paul is a CERTIFIED FINANCIAL PLANNER™ and a member of the National Association of Personal Financial Advisors (NAPFA) and the XY Planning Network (XYPN). In 2018 he was named to Investopedia's Top 100 Financial Advisors list.