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?
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I do agree with you that risk and return are really related to one another. If an investor is afraid of risks, then I don’t think he’ll do good on his investments. It really depends on us on how we are going to manage those risks.
Good points Mark, I think as long as an investor understands the risk they’re taking, nearly any investment will be suitable. Some might be better than others but that’s up to the investor to deal with..
I try to have a balanced approach to investing without the using bonds. I mix risky with less risky investments to balance volatility and still achieve growth. It is asset allocation and my long term goals that I use to achieve it.
Sounds good, so what do you use for your fixed income portion if you don’t invest in bonds? Or are you 100% stocks??
I think that risky assets have their place in all portfolios, just in varying amounts depending on your investing strategies and goals.
Yea definitely agree with that statement, especially if you can afford to take the risk.
I agree that there is a relationship between risk and reward, but just because there is more risk, it doesn’t necessarily mean there is more reward to be had. For example, I’m sure you could find someone willing to sell some Enron stock, and it would certainly be risky, but there really isn’t much potential for reward.
Good point, there are definitely some bad risky investments that are too risky for the return but there are also some on the opposite end of the spectrum. I mentioned Lending Club in the article because I feel they are one of the latter.
Interestingly enough, this is exactly what we have been discussing this last week in my economics class. What do you think is the best balance between risk and return? A mutual fund possibly?
Awesome, I think it’s actually a really interesting topic. Most people will say it depends on your age and risk tolerance, but I think age is more important. I’m not sure how old you are but I’m assuming college age if you’re in an econ class so I’d say 90/10 is a no brainer since you have a 30-40 year investment horizon. Investing does get less efficient though as you move towards 100% stocks since you’re getting less and less of a return for more and more risk.
Everything in finance has risk. Even cash has inflation risk. Everyone must adjust their investing risk based on their need for risk versus time. John Bogle advocates that a good rule of thumb for risk is to use your age as the percent of your portfolio in bonds.
That’s true, Bogle has some solid ideas but I think they are too conservative for younger investors who know what they’re doing. I’m 26 but I hold 90/10 since I have almost 40 years to go before I retire. I don’t care what happens in the next 40 years, I’m not going to touch my 401(k)/ira’s/hsa’s 🙂