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Risk vs. Reward Thumbnail

Risk vs. Reward

The old saying goes “You need to take more risk to earn a larger reward”.  The saying can be applied to business, athletics, and, of course, investing.  But is this concept always absolute?  What does it mean for you personally?  After all, not everyone has the right personality to take large risks and for them doing so will likely end badly as they may not have the emotional fortitude to see the process through.

In this post, we’ll review some concepts related to risks assumed in the process of a personal investment plan for individual investors.  We’ll also examine concepts such as risk tolerance differences between genders and the impact that time has on risk taking.  Lastly, we’ll explore the difference between transitional risk and permanent risk.

First, let’s define risk.   It’s fair to say that risk is generally defined as the potential that the money you invest into an investment opportunity will lose value or all the money could be lost in the case of a business failure or bankruptcy.  Certain asset types have a larger chance of this type of loss occurring.

In general, the list of asset types below is ranked from safest to most risky.

  • Cash equivalents (CDs and money market)
  • Short-term government bonds
  • Long-term government bonds
  • Mortgages – commercial & residential
  • Corporate bonds
  • High-yield corporate bonds
  • Large company stocks
  • Small company stocks
  • Emerging market stocks
  • Venture capital

It is also fair to say that, again, in general the long-term investment returns from these various asset types would be in order from low risk to high risk based on historical evidence.  For investors pursuing a long-term growth plan, they should be investing in the assets on the bottom half of the list.  They should also be prepared to deal with periodic bouts of volatility, usually when the economy is at risk of entering a recession.  Later, we will explore the concept of temporary risk versus permanent risk, which is a very important distinction when planning and managing an investment portfolio.

Personality and ability to accept risk are a big deal.  For those whom short-term fluctuation in asset values creates stress and perhaps the need to seek safety, taking too much risk is a mistake.  The moments of bad decisions are usually caused by fear or greed and those moments are usually the worst time to make decisions when viewed with the benefit of hindsight.  The ability to take risk should be thought through as well.  If someone has an investment portfolio worth $10 million and they temporarily have a decline in value to $6 million, they will probably be okay if they are patient.  But for someone with a $1 million portfolio who temporarily experiences a decline in value to $600,000, it may put their retirement income plan in jeopardy because their lifestyle expenses are larger relative to the size of their assets compared to the wealthier investors.  The wealthier investor has the “ability” to assume more risk, should they choose to do so.  Ironically, the more wealth and ability an investor has to assume risk, the less the need to do so.  Money is an interesting dynamic!

We use the term “in general” quite a bit because there are always exceptions and differences to any assumption we make.  But, in general, women are more conservative than men when it comes to risk taking. This is driven by a desire in women to have more certainty as to their lifetime income.  For most women, one of their biggest concerns is running out of money during their lifetime and declines in portfolio value, even if temporary, create doubts that can lead to poor decision making.  The ideal portfolio will still contain some volatile assets, like stocks, but not such a large proportion that the overall portfolio value decline will cause doubts about the future.  Implementing a time segmentation approach to retirement income planning can also go a long way to creating confidence.

Lastly, it is important to understand the difference between temporary loss of value and permanent impairment of capital.  Since the year 2000, the stock market has lost 50% of its value two times and over 30% more recently when the COVID -19 pandemic caused economic shutdowns.  Yet, as write this blog post the stock market has recovered all of the previous losses and is at record highs.  These losses were temporary, and the best course of action was to stay invested during these events, or better yet take advantage of them by investing more.

Permanent impairment of capital means that the money is never coming back to you.  This occurs when a company goes bankrupt, and their stock and bond become worthless.  Obviously, the whole stock market has never gone to zero.  So the message here is that diversification across the stock market and different asset types reduces the chance of a permanent impairment event.   If you have 1% of your assets in a company that goes out of business, you may not even notice.  If you have half of your money in that company, you will not only notice, but your future retirement income plan could be in jeopardy.

Call us today at (941) 778-1900 or visit www.integracapitaladvisors.com to schedule a conversation about techniques to create more certainty in your investment and retirement income plan.