You May Need to Take Some Risk to Meet Your Goals

Jane Young, CFP, EA

Jane Young, CFP, EA

Before you start investing, it is important to understand the relationship between risk and return and as well as what level of risk you are comfortable taking.  Generally, an investment with a higher return will involve taking on more risk.    If all investment opportunities provided the same return, everyone would select the least risky choice.  As a result, a more risky investment must provide a higher return to attract investors.  At the most basic level, an investment is where one party needs money and another party has money to lend or invest.  The investor does not want to lose his money, so he demands an increasing level of return as the risk increases.

There are many different kinds of risk.  One of the most common is market risk, or the risk of losing money in the stock market when the price of stock falls.  This can be caused by a change in the overall economic situation, impacting the entire market, or by a change within a specific company.  A commonly accepted practice for decreasing this type of risk is diversification into many companies in different industries and different geographical locations. 

When investing in fixed income or interest earning investments, such as bonds and CDs, the most common risks are default risk and interest rate risk.  Default risk is the risk that the bond issuer will become financially insolvent or bankrupt.  Bond issuers are rated based on their stability to help investors gauge how much risk they are taking.  Interest rate risk is the risk that interest rates will increase after you have purchased a bond or CD, resulting in a drop in the current market value. This is of greatest concern if you own a bond fund or don’t hold an individual bond to maturity.

Two additional risks that many investors fail to consider include opportunity loss and inflationary risk.  If you try to avoid risk by avoiding the stock market, you may hurt your chances to earn a decent return.  With current interest rates on CDs and Treasury Bonds so low, conservative investors may be unable to keep up with inflation and build their retirement plans to desired levels.   Volatility in the stock market can be very scary, but over long periods of time it has outperformed most other investments.  By avoiding the stock market you take the risk of missing out on the higher returns provided with a more balanced portfolio.  You may even lose money, if inflation exceeds the interest rate on your CDs.

Moderation is the key.  Investing your entire portfolio in the stock market is far too risky, but investing your entire portfolio in fixed income is also risky.  You risk losing the opportunity to earn a reasonable rate of return, to keep up with inflation and to meet your investment goals.  The best plan is a diversified portfolio that meets your investment timeframe and long-term goals.

Almost Whole

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Jane M. Young

I am continually surprised by questions from financial reporters who are still asking how my clients are faring after losing half of their retirement savings or by individual investors who are still fretting over losing half of their nest egg. If you followed our advice, as about 95% of our clients did, to stay the course and avoid selling during the drop in the market you would be close to break even now. If your risk tolerance precluded you from staying in the market, you may have realized a greater loss. This is a good reminder that we need to avoid acting on emotional reactions to the stock market. The stock market is cyclical and you can’t recover from a loss if you aren’t in the market. The stock market is counter intuitive – generally, the best time to buy is when you feel like selling and the best time to sell is when you feel like buying.

Here are some figures that will illustrate the actual change in the market over the last three or four years. The S&P 500 hit an all time high of around 1561 in October of 2007 and dropped about 56% to around 683 by March of 2009. Since March of 2009 the market increased by about 88% to 1286 on January 31, 2011. While it hasn’t reached the peak of 1561 it has returned to the 1200-1300 level where the market hovered throughout the summer of 2008 – before the significant drop in September 2008. The NASDAQ hit an all time high of around 2810 in October of 2007 and dropped about 54% to around 1293 by March of 2009. Since March of 2009 the NASDAQ has increased by about 109% to 2706 on January 31, 2011.

10 Investment Principles that Never Go Out of Style

Jane M. Young CFP, EA

Frequently people talk about how everything is different and we should change the way we invest. Yes, we have just experienced a very difficult year with some major changes in our economic situation. However, every time we go through a major market adjustment if feels like “this time is different”. We could take numerous comments made at the end of the last bear market and insert them into today’s headlines without missing a beat. I call this the “recency effect”; bad times always feel more desperate while we are experiencing them. We need to step back and look at the big picture; don’t throw the baby out with the bathwater. Good, sound investment fundamentals are still valid. Some people may reassess their tolerance for risk, start saving more money or cut back on their discretionary spending – but the following investment principals are good, time tested guidelines that everyone should follow in any market.

1. Don’t time the market – The stock market is counter-intuitive. Generally, it may be better to invest when things seem most dire and sell when everything is rosy. It is impossible to predict the movement of the stock market and history shows that those who do frequently miss out on big upswings.

2. Dollar Cost Average – This enables you to invest a set dollar amount every month or every quarter regardless of what the market does. As a result you buy more shares when the price is low and fewer when the market is high. Dollar cost averaging helps you mitigate risk because we don’t know what the stock market is going to do tomorrow.

3. Maintain at least 3 to 6 months of expenses in an emergency fund – This is especially important in difficult financial times when stock market values are low and unemployment is high. Unless you have a very secure job I currently recommend a 6 month emergency fund.

4. Don’t invest in anything you don’t understand – If you just can’t get your head around something after it’s been explained or you have done a reasonable amount of research don’t invest in it. If an investment opportunity is overly complicated something may be rotten in Denmark.

5. Don’t Chase Hot Asset Classes – Today international funds may be skyrocketing and tomorrow it may be small cap domestic stock funds. Don’t forget what happened to the stock market after the dot.com bubble burst.

6. Diversify, Diversify, Diversify – Everyone needs to diversify with a mix of fixed income and equity investments that is consistent with their own unique investment goals and objectives. Although most stocks dropped in unison over the last year, I still think there is value in diversifying between different types of stock mutual funds. I believe we will see some categories of stocks outpace others as the market rebounds. Depending on your risk tolerance, a small allocation in commodities and real estate may be advisable.

7. Don’t Make Emotional Decisions – Many investment decisions are triggered by fear and greed and they are equally damaging. Don’t make rash decisions based on emotion. Remember the stock market is counter-intuitive.

8. Don’t put more than 5% of your assets in one security – Any given company can go bankrupt as we have seen with many financial and automobile firms over the last year. I encourage the use of mutual funds over individual stocks to help mitigate this type of risk. If you do invest in individual stocks don’t put too much faith in any one company. If you are investing in your own company and you have a strong understanding of the firm’s performance you could go up to 10%.

9. Be tax smart – Take advantage of tax advantaged retirement plans such as Roth IRAs and 401k plans. Consider tax consequences when re-balancing your portfolio. Use a bear market to harvest some tax losses and off-load some bad or inappropriate investments.

10. Be aware of fees and surrender charges – When selecting investments be aware of high fees and commissions. Tread cautiously with anything that contains a contingent deferred sales charge. Many clients have come to me with a desire to sell or transfer previously purchased investments, usually annuities, only to find they have a 5-10% surrender charge if they sell within ten years of purchase. A surrender charge can have a big impact on your flexibility. If you really want a variable annuity buy one with low fees and no surrender charges.