We should invest in such a manner that we don’t lose sleep at night. Some can handle investing in 5 different ventures to have 4 fail, while others can’t even get themselves to take their cash to the bank.
What Is Risk?
We take on risk when we invest, that’s the gist of risk as it relates to money.
We protect our assets by insuring them, thereby decreasing risk.
We diversify in order to spread out the risk.
Investment risk is the chance of losing a portion of your initial investment. Technically, there is always a risk. It’s just that in our vernacular, risk is used to describe a certain chance at loss which is beyond the comfort level of the majority.
But there is stagnation risk too, where your assets don’t keep up with inflation, eating away at the value of your investment.
Why take a risk?
Our modern economies run on currency. Compared to a few centuries ago when bartering was the main mode of transaction, now it’s done through assigning an arbitrary value to a paper or digital currency and having everyone trade off of that.
The majority of our efforts is spent on securing more of that currency. After securing it we need to, at the very least, preserve its value.
Coincidentally, or, more likely, intentionally, currencies inflate over time which means that those who rely on currency must mobilize it in order to maintain its value.
For most, maintaining the value of a currency isn’t enough, they also want to increase its value. It doesn’t feel right for a gang of cash to sit around and do nothing. Enter, investing.
When we invest, we take a certain risk in return for a chance at preserving and increasing the value of our savings and in order to generate an income.
Risk Can Decrease Automatically
For a person interested in investing in real estate, they might go and buy a single family home and rent it out – bam, they are now a landlord and they are now a real estate investor.
However, they aren’t diversified in real estate. They have one unit, one tenant. The building could go kaput or they might end up without a tenant for a while.
If they purchase a multifamily unit then they are diversifying in the tenant category but still own only one unit… you get the picture.
When we invest in securities, index funds are favored because there are multiple businesses held within the index fund. If one fails there will be others which might succeed.
So risk can decrease by diversification.
How to control risk
We talked about diversification. You are still exposed to the same individual risk but your cumulative risk is lowered. The more reliant you are on the value of your investment, the more diversified you have to be.
You can lower risk by insuring your assets. You get home owner’s insurance, auto insurance, umbrella insurance and you get disability insurance to protect your biggest asset, your income.
The kind of investment you choose has the most bearing on the risk of your overall portfolio. Equities have higher risk while bonds have a lower risk. Emerging markets have higher risk while US stocks have a lower risk, in comparison.
You can also decrease your reliance on income. If we are talking about the risk of return then lowering your household expenses won’t matter. But we are talking about a more global risk, in which case lowering your expenses is probably one of the best ways to curb investment risk in the most tangible manner.
By being less reliant on our investments we could even go for slightly riskier investments and increase our rate of return while maintaining a low reliance on the income from that investment. This is a bit of a circular argument but it makes sense if you plan on doing more with your income than just buying consumable goods.
What’s your risk tolerance?
When I was poor, with a negative net worth, I didn’t mind taking a lot of risks, mostly because I placed very little value on money out of ignorance.
When I started having decent savings, somewhere in the $300k range, I started really worrying about losing it all. I constantly worried whether my investments were too risky, whether I was adequately diversified, whether I should just move all my money into a savings account or CD.
Now that I have reached my savings goal and decreased my reliance on income, I have little fear of losing all my savings – my risk tolerance has gone up. This time, not out of ignorance, I have a better understanding of the relationship of risk:return.
My most effective risk mitigation was lowering my expenses and living a happier life on less.
I now have a small, very small, portion of my savings with which I dabble in higher risk investments. There is a chance for thong-sexy gains but also granny-panty losses.
Is the higher risk worth it?
Now, if you have no problems with taking higher risks then it really shouldn’t matter what you invest in, as long as it’s a sound investment. What’s a sound investment? It’s something I am still trying to figure out and need to research more.
If however, you are more cautious then you are likely debating whether you’d be better off financially going for the higher returns. In these next few paragraphs, I want to lay out some numbers to illustrate the value of such risk.
Index funds are low risk
In the current market, as of 2017, investing in index funds is considered to be one of the lowest risk investments. No, not as low-risk as a savings account or a CD, but low enough that the potential for returns is realistic.
The potential returns, after fees and taxes and inflation, are probably in the 3% range. Some say it’s actually as low as 1% while others say it’s as sweet as 5% – let’s go with 3%.
By investing in index funds you assume that every few years you could lose somewhere in the 15% range, that most years your funds will likely appreciate by 8-10%, and that 1-2x in your lifetime you will lose about 40-50%. After it’s all said and done, you will come ahead an average of 3% per year – hence the 3%.
CD’s are even safer but…
CD rates are about 1-2% right now. Inflation is higher than the CD rates. Which means, you will likely lose money by having your money in a CD.
This is very cursory, there are a lot of other factors to consider here before saying that a CD is a bad investment – but, as far as inflation and rate of returns go, a CD sucks ass.
I want 15% returns
Let’s say that those anorexic 3% returns just don’t appeal to you. Perhaps you are looking at junk-in-the-trunk 15% returns such as the crowdfunding in real estate or options trading or day trading.
Of course, if the risk for these investment genres wasn’t higher then the return wouldn’t be higher – such is the nature of the risk:return relationship.
Your investments won’t go up 15% year after year. They will go up 34% one year, 40% another, then 21% and then drop down 60% and flatten out for 3 years or maybe even drop some more. Then they will go up 70% and drop 33% then go up by 8%.
If you invest $100k at 3% and add $30k/year for 20 years then you will end up with $1,000,000.
If you invest the same $100k at 15% and add the same $50k/year for 20 years then you will end up with $6,000,000.
So, you could end up with $1 million or end up with $6 million from investing the same amount, starting with the same initial sum for the same duration of time – the only difference being the investment vehicle.
The simple question is whether you can sleep soundly at night knowing the much higher risks involved with your alternative investment option.
What about 150% returns?
One of my friends was an Angel investor and has since graduated to VC investing. He sold off a startup right after college and got involved in the Angel community. He now invests in 5-8 ventures every year and expects 80% to fail, 15% to give him flat returns and 5% to give him 500% returns.
He would never invest unless he could double his money every 1-2 years. That’s a whole another risk profile with amazing return potentials.
That said, he seems really connected into the startup community and researches the shit out of every one of these startups and knows quite a few of the CEO’s leading the startups in which he invests.
When he talks about business structures we are no longer speaking the same language – I have no fucking clue what he’s talking about. Speak English dude!
I think with these higher returns it’s not just the hours of sleep you’ll lose over the risk of the investment but also the hours you are willing to spend researching the venture.
My personal investment approach
I still feel most comfortable knowing that I have an investment which can provide me an income floor. This floor is how much I need to spend every month to live a comfortable lifestyle.
Once I can create this income through my index fund investments, I will look to add a cushion. For example, if I need $2k a month of income then I will need to invest around $800,000 and have a 25% cushion of +/-$500/month.
Once I have this $800k saved and invested, I will look to diversifying my income streams outside of my securities investments. Real estate is such an option or a business, perhaps. The purpose would be to add that 25% buffer.
I feel comfortable owning and working on real estate so I see myself owning income producing real estate outside of a REIT.
I am also comfortable and would enjoy running a business such as an auto mechanic business or a consulting business. As you can see from my postings, I am still figuring this part out.
Investing in one’s skills is a majorly overlooked financial planning strategy. The more marketable skills I can develop the more likely I am to secure an income and the higher the income will be.