Risk is an important factor to consider any time you choose investments. There are a number of risks when it comes to investing, and learning how you can best mitigate those risks now will mean higher returns in the future.
Below are three concepts you’ll need to remember as you’re making investment decisions. Internalize this information, it will serve you and your portfolio well.
1. Understand that diversification is critical.
You’ve heard it said that you should diversify your portfolio. This is one of the easiest concepts to grasp and it is also one of the most important.
Invest in seven ventures, yes, in eight; you do not know what disaster may come upon the land. – Ecclesiastes 11:2 NIV
This timeless investing principle has one critical purpose: to eliminate risk. Keeping a portfolio containing a variety of investments smooths out the rough patches in the stock market. It lowers your volatility.
2. Realize that average annual rates of return can be deceiving.
Let’s suppose for a moment that you were offered three different investments for a two-year period. Of course, you’re looking for the greatest return over the course of two years. Take a look at the investment options below and choose the investment that you think will return the most money two years:
Remember your choice, and consider the average annual rates of return in the table below. Would you change your decision based on this new information?
Now let’s look at the final outcome of these investments:
It’s pretty clear now, that Investment Z wins at the end of the two years. Does this surprise you? See how annual rates of return, and even average annual rates of return can be deceiving?
The reason this is the case is because average annual return rates don’t take into account natural market volatility. If, for example, you have a certain percentage loss in the first year, you’re going to need a higher percentage gain in the second year just to recover the original value you’ve lost.
Consider further, that if you were to not just choose one of the investments but all of them, splitting your money between the investments and rebalancing your asset mix at the end of each year, you would potentially have an even better return. Remember, diversification limits volatility, and volatility can have a negative impact on your portfolio . . . that brings me to my next point . . . .
3. Keep in mind that volatility negatively affects your portfolio.
Slow and steady wins the race. Get-rich-quick mentalities many times lead to lower returns. Think like the tortoise, not the hare.
A faithful person will be richly blessed, but one eager to get rich will not go unpunished. – Proverbs 28:20 NIV
Volatile investments have a negative affect on your returns.
Let’s say you invest $100, which in the first year yields 2%, ending in a balance of $102. In the second year, the investment yields 18%, which means you now have $120.36.
Let’s take that same $100, and say that in the first year it yields 10%, which means you have $110. In the second year, the investment yields 10% again, which means you now have $121.
Notice that the investment that had less volatility, producing 10% in both years, actually faired better than the investment that produced 2% then 18% the following year, even though the average annual return was the same 10% in each investment scenario.
As you can see, volatility alone causes you to lose out on returns. And using larger sums of money, you can begin to understand how important this concept is in your investment strategy.
Volatile investments influence investors to make poor choices.
It’s also true that people react differently to volatile investments as opposed to less volatile investments. Investors, when faced with a dramatic drop in their investments, tend to want to pull out of the market at just the wrong time.
Investors should buy low and sell high, but that’s exactly the opposite of what they normally do when experiencing volatile investments. Caught up in the moment of a loss, they’ll sell when they should have invested. Conversely, if they are caught up in the moment of a win, they’ll buy right when the investment is about to fall again.
By understanding just a few of these risks to your investments, you’ll be better equipped to make appropriate investment choices and be more confident in your decisions.
Remember the risk of volatility, the deceitfulness of average percentages, and the wisdom of diversification. You’ll be much better off if you do so.
What other investment risks can you think of? How can they be avoided? Leave a comment!