Did you know that in five minutes you can know more than about 95% of people do about risk and reward in financial investments?
What do you consider a safe investment? You probably think of bank CDs or treasury bonds right? These typically have low yield or return on your investment. This is the main thing you should focus on…if there is virtually no chance of losing your investment and you expect modest returns; this is what’s called a low risk investment. You should think of modest expected returns as characterizing low risk instruments.
Contrarily, you know that you can make big returns, sometimes at least, with things like stocks or mutual funds or maybe even stock options or other derivatives. Forget the names for a minute. The simple idea is that if you have the potential for getting a big return or yield (i.e. big reward potential) it must be the case that there is a significant risk with the investment. In other words, though you may do well for several years, maybe even many years in a row, there eventually comes poor performance. This may be a low return like 1 % over a year or it may be worse such as a negative return where your investment loses value over a year.
A few years back (before the market meltdown) I heard someone give advice to a young woman: “you have to invest in real estate”. Many people felt that real estate was a high return AND low risk asset class. No such thing.
We should be a bit more precise. An investment that returns -10%, 10% and 30% over three years has an average return of 10% since the average is the sum divided by 3. Another example would be 20%, 30%, 50%, -60%. Note that there were three years
of great returns and one terrible year where you lose 60% of your investment. This still is an average return of 10%. Generally when people think about reward in investing, they think of average return or “expected return”. The risk is the volatility or variability shown in the above returns. Any year may be horrible and you need to be prepared for that.
Consider the bio-tech stock bubble of 1999-2000 or the internet bubble of the late 90s. These stocks looked like sure things with huge returns. To some they seemed low risk high reward investments. No such thing! Hype drove up stock prices but people still thought the big returns would come- they did not. The bubbles burst. Remember, high potential reward means high risk. You have to be prepared for a bad year (or years!).
We see the same thing in corporate bonds. Agencies like S&P and Moody’s provide (sometimes unreliable) credit ratings of bond issues. These ratings indicate the perceived risk of default (i.e. not paying coupons or returning the principle of a bond). What bonds have the largest average return generally? The riskiest…those rated as “junk” or below BBB under the S&P system. It is well known that you are rolling the dice by investing in these unreliable borrowers and you get compensated for it by higher coupon rates or higher yields.
Just know that sometimes you’ll get completely screwed and lose most of your initial investment.
So how should you invest? In safe CDs and treasury bonds or stocks and hedge funds? It depends on your time horizon and your capacity to absorb a hit in a bad year. If you’re in it for the long term, then stocks are important because any bad year is often made up over the very long term. An example would be your 401k plan if you’re still 20+ years from retirement. With that time horizon you can still afford a bad year and stocks
will generally beat safer investments like cash equivalents and high rated corporate bonds. The allocation between bonds and stocks depends on your time to retirement and your ability to absorb a hit, as well as other sources of future income. Conversely, if you want to invest money for a brief period of say 1 to 4 years and don’t want to lose any of your investment than CDs and high quality (highly rated) bonds are safer. Note that most individuals can only invest in corporate bonds through mutual funds since a single bond is usually only sold in very high dollar amounts.
It’s possible for a brief time that some obscure investment type may be low risk and high reward but this is an unnatural and fleeting situation. Once the general public knows about it the cost to invest soars and this erases a lot of the upside potential.
So, the basic lesson is that safer, lower risk investments have low average returns (think CDs, treasury bonds, money market funds) and higher risk investments like, stocks, ETFs, stock mutual funds, some hedge funds, real estate generally have higher average returns over long time horizons but will have the occasional (or frequent!) bad year where you lose some or all of your investment!