Risk and reward

Investment risk and reward – don’t miss opportunities

 

Women often choose only low-risk investments without realizing the long-term effects. This is common in beginner investing. Let’s see how choosing a variety of investments (diversifying) can balance risk with growth. First–let’s take a walk around the neighborhood to see how risk and reward pair up.

First stop is the high school fundraiser fair. A teen waves me towards his game booth. The odds are high that I’ll pay $2 and not get anything in return except the chance to toss some balls and wonder what I’d do if I won a stuffed purple gorilla. In this case, the risk is small and the reward is small.

A block away, a Realtor is meeting with a woman who’s considering buying a house to renovate and resell. The prospective buyer’s investment risk is much higher, but so is her chance of profit and reward.

In the financial world, the risk and reward relationship gives clues to what you can expect from an investment. When the risks are low, the rewards are usually low. And when the risks rise, so do the possibilities of larger returns. Notice, there is no guaranteed relationship here, but the law of averages does tend to follow.

The financial meltdown of 2008-2009 left investors scrambling for low-risk places to put their money. Avoiding losses became more important than growing investments, so people piled into Treasury Bills or bank CDs which paid 1-2% per year. In times of crisis and uncertainty, this is a normal response. Every investor (and that’s you if you’re saving for your future) needs some low risk investments.

But it’s also important to plan for growth in your investments. Many of us will experience over 25 years in retirement. That’s a lot of years and savings to plan for! One reason many women face poorer retirements is due to picking only low risk investments that provide little or no growth.

So how do we strike a balance? I like to point to the food pyramid as a clue.
Remember that chart that shows what proportions of foods one should consume, with grains, fruits and veggies in bigger proportions than meats and sweets. (Darn, they never put chocolate in there as a food group.)

A similar pyramid could be made for investments. A balanced portfolio is one where investments are spread into different types and classes, with stocks, bonds and low risk cash all represented. (Your “portfolio” is all the investments you own.)

Most women who won’t need their investments for a decade should keep the bulk of them in growth or balanced mutual funds or something similar. Smaller amounts can be in things that don’t grow much (cash accounts, Certificates of Deposit, Treasury Bills). You can also keep a small amount in more risky or speculative investments (small growth stocks, foreign mutual funds, junk bond funds, etc.). Your blend should be determined by your proximity to retirement, risk tolerance and need for current income.

Let’s look again at that food pyramid. If all your savings/investments are in safe, low risk products, that’s like trying to live on a diet of oatmeal 3 times a day. You’ll fill your stomach, but you won’t grow much. On the other hand, if you branch out and add investments with the potential for growth, like stock mutual funds, you’ve just added more courses and your future growth will likely be healthier.

Let’s run some numbers here. If low risk investments earn you an average of 2% a year, where does that get you in 20 years? If you start with $10,000, earning 2% a year with monthly compounding, it comes out to $14,913 in 20 years. But wait, if inflation averages 3%, that investment has a purchasing power of only $8,178 in today’s dollars. That’s going backwards, and not much of an investment. (Inflation is almost flat now, but will probably increase as the U.S. struggles with its economy.)

But what if you took that $10,000 and put $1,000 into a low risk investment at 2%, $8,000 into a balanced fund earning 6% and $1,000 into a high growth mutual fund averaging 10%? This is the equivalent of a balanced diet for someone with many years until retirement.

You’d now have $35,301 in 20 years. With 3% inflation factored in, your nest egg is worth $19,360 in today’s dollars. That’s more than twice the $8,178 in the low risk scenario, and it’s all due to using the proper asset allocation, or best balance for your long term goals.

While there is no guarantee of performance, the odds are much higher that a balanced investment blend will outperform the low risk approach over a period of time that spans a decade or more. So, for long term goals, growth investments need to be in your portfolio mix if you’re aiming for financial security.

Robin Applegarth CRPC®