Assessing Invest Risk In Your Portfolio
In medicine, you need to work harder, have better grades and hustle more in order to get into the more soughtafter residencies. I could have never been an ENT or Ortho resident, I was a happy slacker. The residency would have been tougher, longer and I probably would have had to study harder for those Steps.
Just like in medicine, investments have a risk gradient. On one end are fairly easy, straightforward investments with low returns and on the other are riskier ones but with a higher chance of sexy returns. The spectrum of investment risk is important in order for you to make the right financial decisions regarding where you park your savings.
You Are Always Taking On Risk
Even if you just put your money in a savings account, you are taking on risk. Your money is never 100% guaranteed, no matter what anyone tells you. In our American economy, we are not only used to but come to expect “someone” bailing us out, which can create a false sense of security regarding our investments.
If inflation starts to suddenly go nuts then your $100k sitting in your checking account will lose value in as little as a few days. You can go to withdraw it but during hyperinflation scenarios, banks would likely shut down from the mere demand. Often, these events are temporary but the value will have bled out.
Sure, your money is insured, for up to the FDIC limit. The face value is insured, not the purchasing power. After some lengthy negotiations and paperwork, you can likely get the FDIC to cut you a check for that $100k previously held at the now-broke bank. What that $100k can buy you after some hefty inflation, is another story.
Let’s go over a few common investments and talk about their associated risks, as accepted by the financial community.
Very Low Risk: CD, Certificate Of Deposit
A CD, certificate of deposit, is insured by the FDIC up to $250k. It’s basically a savings account but instead of you having constant access to it, the money stays in for a specific period of time.
Currently (2017), a 5-year CD will give you a yield of around 1.75% annually. So by the end of the 5-year period you would walk away with $53k from a $50k initial investment, as an example.
You would be responsible for paying taxes on this money, which generally is as high as your highest income bracket. When I was working full-time, that would have been around 30%.
Sine the FDIC insures only up to $250k, most investors will invest high dollar amounts into various CD’s. Also, for those who want to create income streams from CD’s, a CD ladder can be created in order to generate a steady income stream.
Very Low Risk: Treasuries
Treasury Securities are bonds sold by the US gov’t in order to finance its operation. Not much different than the old war bonds, except it’s more PC now to call them treasuries.
These are considered incredibly safe and yes, they are guaranteed. Just know who they are guaranteed by, the United States of America. For the most part that’s one hell of a trustworthy borrower, but don’t forget the USA currently has an outstanding debt of around $19,000,000,000,000, and it’s going up every year – there is no viable plan for this debt to be ever paid off.
Still Very Low Risk: Savings Accounts
These are obvious, right? You probably have one of these open somewhere along with your checking account. They offer very little as far as yields. Somewhere in the 0.05% range. Park $500,000 in this account and you will end up with a $250 profit by year’s end. Oh, you would still owe taxes on this jaw dropping profit.
Money market accounts are no different than savings accounts and no different than checking accounts that offer interest rates. Our banking system, unfortunately, uses a whole lot of different terms to make stashing your money less transparent.
The lack of transparency is used to charge fees, fees are used to bring you more unnecessary investment products.
Low Risk: Municipal Bonds
Though bonds in general aren’t risk-free, they have some of the lowest risk-profiles around. A municipal bond is essentially where you lend money to a large entity, a local government for example, to build infrastructure. The common examples are school, roads and hospitals.
Muni’s are most popular for their subsection of tax-exempt bonds which usually have a little lower yield than taxable counterparts, but the added benefit is that they are federally not taxed and usually not taxed on the local (state) level, either. This is great if you are in a high tax bracket.
The uber-wealthy commonly have a decent amount of their cash parked in such accounts. My old CPA showed me the anonymous tax return of one of his clients who was grossing $250k a year from his investments in muni’s… nice.
Lower Risk: Annuities
Annuities can get a bad rap because they are often sold by greedy salesmen to consumers who don’t know any better.
However, don’t get it twisted, annuities can be amazing vehicles to generate income for retirement. Some can even help you save quite a bit on taxes.
There are all sorts of annuities and some are best sold but ideally not bought. These, too, are guaranteed. See the pattern? Seems like most investments which suck ass are guaranteed.
Lowerish Risk: Investment-Grade Corporate Bonds
Corporate bonds are monies lent to corporations. Those which are rated BBB and higher tend to be fairly safe investments. However, just like any investment, if the parent company eats shit, so will the money you invested in them or lent to them.
You ever heard of Junk Bonds? Yes, investors actually invest their money in such things, despite their reassuring name. These offer a chance for high returns with high risk. These are NOT good investments for the average investor.
Medium Risk: Broad Index Funds
So, circling back to index funds, all the rave of the current financial community. Just like CD’s used to be the “solution” to a safe retirement, index funds are touted to be the surest way to ensure a steady income stream.
There are index funds which invest broadly and there are those which only invest in US stocks or only in foreign stocks, and even more specific ones which invest in particular sectors or bonds etc.
These specific index funds belong in the moderate risk category (discussed below), while a broad index fund, which is well diversified, has a lower risk and is considered medium risk.
The risk comes from the fact that at times they can drop in value by around 25% or even more. Though, anecdotally, such investments tend to recover with enough time on your investment horizon.
Investing in individual stocks could be considered riskier, due to the lack of diversification. Investing in broad index funds, which could be a conglomeration of stocks and bonds, is considered a bit safer and would fall into this medium risk category.
Moderate Risk: Stock-only index funds, smaller company stocks, real estate
Among stocks, there are higher risk companies which tend to move a lot more and there are lower risk ones which generate steady but not sexy returns. You’ll hear the terms value, growth and small-cap, etc.
If you invest in specific index funds then you are jumping from medium risk to moderate risk. And if you hold mostly small-cap stocks in such index funds, then you are increasing that risk even further.
For those who feel comfortable investing in index funds, it’s wise to have a specific asset allocation of safer index funds and riskier ones.
Interestingly, real estate income falls into this category as well. Whether it’s REITs or individual rental income properties, the risk tends to be moderate. The more sepculation you have to do, the higher the risk. We’ll talk about that in a bit.
High Risk: Small-cap equities and individual stocks
Anytime you invest most of your money into only one investment, you are taking on a higher risk. I’ve talked about this before, it’s similar to having only 1 client in a business versus, having multiple customers.
We talked about the small-cap stocks already. These tend to move a lot, not always up. But when they move, one can generate some fairly decent income from them.
Again, don’t discount small-cap stocks, these certainly belong in a portfolio of someone who is comfortable investing on Wall Street. Supposedly, some try to develop an expertise in a specific sector, therefore increasing the odds that their small-cap investment will pay off. Yes, it’s speculating… but so is investing in damn near anything.
It’s considered riskier whenever you invest more into a particular sector. If you recall the tech bubble in the early 2000’s, it hit Wall Street hard because most money was invested in tech. Well, guess what, when you invest in broad, passive index funds (medium risk), they invest in the largest companies and so technology is often the leader of the pack. I’m not saying it’s bad, just mentioning it so that you are aware.
Risky As Fuck: Anything that you have to speculate on in order to profit
Okay, so what constitutes high risk? If you buy a piece of art, assuming that it will go up in value, then you are speculating on it’s future value and therefore it’s a speculative investment. Is that a bad move? No, but you better have some sort of a slightly safer investment as a backup as well.
A friend of mine invests in very expensive Whiskey, so far he’s doing quite well. He is improving his chances by connecting with some very wealthy Chinese families, a niche market with high demand for his product. Even if a certain sector of the economy collapses, these families are invested broadly enough that they will continue to buy expensive Whiskey.
If you buy a piece of land, hoping that it will go up in value in the future, then you are speculating. I’m sure investors in the 1970’s in California were speculating, needless to say, it paid off incredibly well for them.