Risk and Reward

You have probably heard that every investment has a risk/reward trade-off.  If not, it's true.  Now, let's take that further.  Every non-investment has a risk/reward trade-off.  Every time you decide not to do something or simply do not even consider options or reflect on how you use your money, that carries its own risk. 

In fact, you may be in your current situation because you didn't even consider the risks of not planning for or creating your personal economic recovery.  You may have simply spent, assuming that you could afford what you were buying.  You may have accumulated credit card debt because you didn't think about what the 18% compounded interest would do to you after a few years. 

There are risks to every choice.  Some will say that purchasing lottery tickets is stupid.  That's certainly true if you are not thinking about why or how much you are spending on lottery tickets, but those same people may be wasting money on other things every day.  I buy a lottery ticket once in a while for fun.  I don't buy a lottery ticket thinking that it's part of my personal economic recover plan.  There are also risks to doing nothing with your money or in not planning so that you buy stupid stuff with your money instead of investing it.

Many investment companies will try to help people develop investment strategies based on their risk tolerance level.  That's an interesting idea, but the truth is that every person needs to take some risk and some people need to take less risk.  A person who is risk averse usually needs to learn to take more risk in handling money, not unnecessary risk, but appropriate risk to meet goals.  There is a risk in not taking risks.  This is something that few gurus talk about.

I just read a story about a person who was advised by his financial planner not to invest in a small business.  The individual defied his financial planner's advice and created a successful business.  Starting the business involved more risk than most people would be willing to take on, but with hard work and good implementation it worked. 

I also recall a guy who was about 30 years old and wanted to put all of his retirement investments into US Treasuries because the money would "be there" when he retired.  The risk is that he won't reach his retirement goals and he would have to invest about twice as much money as he thinks he would. 

If I'm over your heads right now, I'll back off and hit some basics of risk and investing.

So, there are different kinds of risk.  There is market risk, which is what we usually think about.  That's the changes that go on in stock prices across the market.  For many mutual fund investors, that is what has the most impact on their investments.  That's what most people worry about, and that's not all bad.

There is also inflation risk and interest rate risk.  If you keep your investments in US Treasuries right now, you are earning less than the inflation rate.  You are not actually investing.  You are saving. 

Interest rate risk is a little more difficult to understand because it seems to violate intuition.  If you invest in bonds, for example, and interest rates go up (as they are likely to do at some point), the value of the bonds will go down.  That is because people who want to buy your bonds will want a higher interest rate will want to buy them for less than you paid for them.  You will have to sell them at a discount in order for people to buy them.  In reality, it's likely that you'll buy into a mutual fund bond fund that will sell the bonds for you, but you will be impacted by the changes in interest rate. 

There is also a risk from lack of planning.  This is not a formal risk, but if you do not plan for your personal economic recovery, then you risk not hitting your goals.  You need to plan and stick to that plan.  A friend of mine often reminds me that "hope is not a strategy."  You need to plan your investing and ensure that you stick to that plan.  Just like my lottery ticket purchase, your purchase of a new washer and dryer could be stupid, if it's not in your plan.  Of course, if you don't have a plan, then you don't know if it's stupid or not.  That's a risk to avoid.