Investing is like life: nothing ventured, nothing gained.
If you want to meet your financial goals, you’ll have to learn to live with a certain amount of risk. Risk means that as your investments fluctuate in value over time, one or more of your holdings may be worth less than you paid for it.In fact, some investments may turn out to be virtually worthless—or really and truly worthless.
But you have to take some risks to get a significant return on investment, sometimes abbreviated as ROI. Return includes income you get from an investment, such as dividends or interest, and any gain, or profit, from selling the investment for more than you paid to buy it.
For example, say you buy 100 shares of stock for $35 a share, collect a $75 dividend, and sell it for $40 a share. Your return is $575 on the investment: $75 in dividends plus a $500 increase in value (100 shares x $5 increase per share = $500). If you realize that return in one year, your rate of return on the stock would be 16.4% ($575 ÷ $3,500 = .164 or 16.4%).
That’s a very good return, especially compared to what you could be earning on the money in a savings account. But that return isn’t guaranteed in the next year. In fact, the value of the stock could drop just as easily as it could increase. That’s where risk comes in, and why you can lose money when you invest.
Suppose you needed cash when the stock price had dropped to $32 a share. Even if you collect $75 in dividends, you’d lose $225 by selling at the lower price [100 shares x $32 a share = $3,200 sale price – $3,500 purchase price = –$300 + $75 dividends = –$225]. That’s a loss of 6.4% on your investment.
NOTHING TO FEAR BUT…
If the idea of risk scares you, get used to it. As an investor you can approach risk in three ways: Embrace it, try to avoid it, or find a way to use risk to your advantage.
You might find risk exhilarating. Taking lots of chances on start-up companies or concentrating on just one or two investments means you’ll either make a lot of money or kiss your principal goodbye.
You can try to avoid risk by choosing investments that pose little or no danger to your principal. That includes insured certificates of deposit (CDs). But avoiding what you think of as risk makes you vulnerable to one of the biggest investment risks you face—inflation, or the long-term loss of buying power.
By spreading your investments across the range of possibilities, including both the safest and the riskiest categories, you can avoid the risk of having all your eggs in one basket without giving up the potential for a positive return. And if you stick to stocks, bonds, and the mutual funds that invest in them, the most you can lose is the amount you invest.
Risk has many faces. The sooner you learn to recognize some of the most common ones, and where you’re apt to encounter them, the less scary they should be.
Investment risk, sometimes called business risk, is the possibility that an investment will not produce the results you expect. For example, suppose two new technologies are introduced at about the same time, both innovative and workable. But only one of the technologies is widely adopted. If you invested in the one that doesn’t survive, you may well lose money. But investing in the successful one may produce a substantial return. And if you’d invested in both, your gain in one might offset your loss in the other.
Management risk refers to the possibility that a company’s management team may make serious mistakes in directing the company. Whether these errors result from honest miscalculation or from negligence, they can have major financial consequences for the company’s stock, resulting in substantial investor losses. On the other hand, superior management can produce outstanding results under certain— though not all—market conditions.
Market risk is the possibility that the equity or bond markets as a whole may drop in value, as may happen in a periodic correction or a more serious recession. In that type of economic climate, the prices of even the most stable investments tend to decline.
No matter how alert you are as an investor, it can be difficult to anticipate a market drop. Historically, however, strong markets have always been followed by a period of loss, and then by weak markets recovering, and growing stronger.
VERY RISKY BUSINESS
Market timing, also known as day trading, is an attempt to make quick profits by buying and selling investments to take advantage of minute-to-minute price changes. With the speed and accessibility of online trading, it has attracted a lot of attention in recent years.
But it’s like playing Russian roulette. You may survive, and even make a profit. Since there’s no way to predict how prices will move, especially over such short time spans, market timing means you could lose a lot of money in a real hurry. To make matters worse, each time you trade you pay transaction fees. So you could be paying to lose money.
AS CLOSE AS YOU CAN COME
There’s no such thing as a completely risk-free investment. The only thing that comes close to being risk free is the 13 week US Treasury bill. Since it’s backed by the federal government, there’s almost no chance that the principal won’t be repaid. And since the term is so short, there’s no real danger from a major loss of value.