Investing Rule #1 – Risk and Return Will Always Be Related

Ever since I started writing about personal finance, all of my friends loved talking to me about their investments.  Even though I’ve always had an interest in investing, saving and making money, it wasn’t until I started blogging and writing professionally that I became an authority on the subject.  Nothing really changed about my knowledge base, but seeing my thoughts in writing somehow made me an authority on the matter.  Now I’m pretty much the go-to resource for all of my friends’ investing questions and help.

Most questions have to do with building credit, saving for retirement and things of that nature.  But I still get a whole lot of questions like, “What stock should I invest in to make a ton of money?” or “I have this awesome investment that’s getting me guaranteed 8% returns right now, can you believe it?”  No actually, I don’t believe it – just remember about the successful stock picker.  Investing it turns out isn’t as sexy as the news and media make it out to be.  It’s actually pretty boring.  You do a bunch of research, you invest in a few stocks, keep contributing and you’re pretty much done.

Higher Returns Always Means More Risk

So when I hear about great investments that are returning 8-10% right now, I usually give my standard response: risk and return are always related.  It’s a pretty boring answer and it’s almost always not what people want to hear, but it’s ALWAYS true.  There are lots of things we can do to minimize the risk of certain asset classes like stocks or bonds, but there will always be associated risk.

I generally look at a very simple marker like the highest available CD rate to tell me where we’re at risk-return wise.  With a CD or a government bond, you are guaranteed to get your money back plus some more so it seems like a good starting point on our risk-return curve.  As you increase risk with things like bond funds, stocks and alternative investments your rate of return will go up.  That’s why we tend to invest more heavily in stocks than bonds, we want to achieve that higher return and we know over the long run, stocks should outperform bonds.  But with those higher rate of return investments, we know that our risk will also go up, that’s why stocks have more risk than bonds.

Risky Investments are OK

I actually don’t mind risky investments at all, but the caveat is that you need to understand the risk and ensure that it doesn’t make up too large of a portion of your portfolio.  If you invest 5% of your portfolio in binary options and you’re expecting a guaranteed rate of return, you are crazy.  But if you understand the risk that you’re taking with your money and that there is a chance you’ll lose your money then go for it.  There’s really only one way to learn with investing and that’s through first hand experience.  Reading about losing $25,000 is a lot different than going out and actually losing it.

Since most people  think they know what’s best for themselves, I never tell people what to do.  Instead, I offer my advice and what I would do if I was in their situation.  If I was going to invest in binary options, I would limit my investment to 5% of my portfolio.  I can’t tell people not to do this or that because I’ve already made a lot of the same mistakes.

My Risky Investments

Even though I do most of my investing in index funds and bond funds, I still dabble in risky investments from time to time.  When I have a gut feeling about a stock, I go for it, it might not be the best idea ever, but sometimes it works, sometimes it doesn’t.  The thing to keep in mind though is that I never invest more than 5% in any of these risky investments.

Other times, I’ll test out the waters with a risky investment with a small amount of money before investing more.  One good example is with Lending Club.  I saw an opportunity where maybe the risk-reward was a little low(meaning the return is higher than it should be for the risk) since it was such a new investment and I decided to jump in.  I started small with $500, and after a year my returns were doing very well so I invested a lot more(but still under 5% of my total portfolio).

There are people who analyze investments as their job and they’re damn good at it.  They are the people who cause the market to slowly adjust the risk-return curve.  If there’s an investment that is returning more than it should be for its associated level of risk, then more investors will flock to it and the return will drop until it reaches equilibrium.  High returns are always possible and I understand the fantasy with them but  you will always have to take on a proportionate amount of risk to achieve them.

Where do your investments fall on the risk and return scale?