Risk: When is it Worth Taking?

By A. Andrew Raub

There is no such thing as a free lunch when it comes to investing. Risk is an unavoidable element because you cannot have return without taking some risks. As with the rest of life, successful investing requires you to learn about the various risks you face and to decide which ones to accept and which ones to avoid. Managing risk therefore, always requires wisdom and tradeoffs. If investment risks are unavoidable, how can the Peace of Mind Investor manage risk and alleviate fear?

Usually we think of risk purely in terms of winning or losing. We hear comments like “that mutual fund is too risky” or “I don’t want any risk so all my money is in CD’s.” However, risk is much more complex than just our gut reaction to an investment idea. For example, avoiding risk by investing only in CD’s may make someone feel secure, but it could create an even greater risk when they can’t earn enough return to make ends meet—the risk of lost opportunity.

Let’s divide investment risk into two camps: “useful risk” and “useless risk.” Risk is useful when it brings about an expected or desired rate of return—when you stand a good chance of getting paid for taking the risk. For instance, investing in a broad market index such as an S&P 500 Index fund will give you both the risk and return of the broad market—an easy tradeoff. However, concentrating all your holdings in one stock may increase your risk many-fold over the index fund, without giving you significantly greater potential return. This is useless risk because you take the risk with very little possibility of increased return. Certain risks are useless when they do not produce a potential return that is high enough for you to take them, or when you can gain the same reward by taking less risk.

The good news is that you can take steps to avoid useless risk. In fact, I recommend doing four things to help avoid the pitfalls of useless risk in your investments. First, have a written game plan. Make sure that you have a financial plan so that you know where you are going with your investments. You should ask yourself two basic questions when mapping out your financial future:

• What do I need out of my investments?
• Which investments will generate what I need?

Having a clear investment strategy is the best defense against emotional decisions that can lead to taking useless risk.

Second, make sure your investments are diversified and match your needs. For example, some investments such as bonds are designed to produce income, and others such as stocks are designed to produce growth. Retirees often need income-producing investments, so investments that only produce growth might increase their risk of not having enough income. Young people saving for retirement generally need investments that generate growth, but it they choose to invest only in bonds they would be at risk of not having enough money to retire on one day. Expecting something from an investment that it is not designed to produce puts you at risk—as does putting all your investment eggs in one basket. Make sure your investments are diversified and line up with your goals.

Third, look for hidden risks. For instance, if you own real estate investments, you might encounter liquidity risk—not being able to turn your investment into cash when you need it. If you own stocks, you might be at risk of the market’s volatility, and if you own bonds, you might be at risk of rising interest rates. Or you might encounter inflation risk—the risk that your purchasing power will decrease over time. Find out about the risks associated with your investments because each type of investment will have its own unique risk characteristics.

Once you have written down your investment strategy, made sure your investments match your needs, and looked at the hidden risks associated with investing, you can now clearly evaluate which risks you find useful and which you find useless. Remember, risk and return are linked when it comes to investing, but you can take steps to manage your risk. That’s the secret of being a Peace of Mind Investor—achieving your desired return while managing or reducing your risk. Investment return requires taking risk, but you don’t have to leap blindly. Choose Peace of Mind instead.