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Tips for Investing—Learn to Understand the Risks

I’ll just come out and say it.  Expecting your investments to consistently pay off big time is just not realistic.Your coworker that has made 40% in their 401(k) last year was lucky (assuming they’re calculating their return correctly in the first place), and they’re most likely conveniently forgetting how much they have lost in other years.  We all have a tendency to remember our successes and forget times we’d rather not relive.  The S&P 500 lost over 53% of its value between October of 2007 and March of 2009, and some noted institutional investors went down with the ship, so to speak.In short, hoping to get lucky with investments is not a strategy that will work consistently, so it’s simply a bad idea to rely on it.  It’s time, not timing, that will make the biggest impact.  So now that we’re depressed about the lack of possibilities, where do we start?

The first step is to understand that all investing involves risk, and to decide to be okay with that. Technically, even choosing NOT to invest involves risk.  Bank deposits may be FDIC insured to guarantee the number of dollars you have. Unfortunately, what those dollars can purchase generally is also more or less guaranteed to shrink over time due to that pesky thing called inflation.  The reason we invest money is because of the possibility that what we invest in will increase in value over time—hopefully faster than inflation.  The higher the expected return on your investment, the more risk you must be willing to accept. 

Part of accepting that risk is learning to correctly define it.  It’s easy to pitch an investment’s average return—the US stock market (measured using the S&P500) has had an average return of close to 10% per year over the past 90 years.  At that rate, your investments could double every 7 or 8 years.  Sounds great, but it doesn’t tell the whole story.  Achieving that rate included losing over 36% in 2008.  Too much loss?Investors that chose to sell their investments after that loss then may then have missed out on significant gains over the coming years (the S&P was up by over 30% in 2013).  

Unfortunately, we have no way to tell when up years or down years will occur, so successful investing means being able to stomach the losses.  We encourage our clients to think of investment returns in terms of a range rather than a target.  Consider setting your goal as “planning to lose less than 10% in a really bad year and being ok with making up to 15% in a really good year,” rather than “planning to make 5% per year.”  Setting realistic expectations will help you to make appropriate decisions and avoid selling out when things get rough. 

It’s not possible to control returns, but you can control risks to some extent.  If you own a single stock, you have a larger potential to “pick the right one” and make a significant amount of return.  There’s also the chance that the company could go bust, and you could lose your investment altogether.  So what if you owned stocks from two companies instead of one?  Now, a bad choice may only affect part of your portfolio instead of the whole thing.  Owning 50 stocks would be better still. 

The next step is to start looking at other types of investments.  Rather than simply large U.S. companies, consider small or mid-sized ones.  Look into fixed income investments such as bonds, or into real estate or alternative investments.  The process of mixing different types of investments into your overall account is called asset allocation.  Choosing asset classes that don’t relate to the ones in your portfolio can lower the correlation between your returns, and lower your risk—potentially without dramatically affecting your return over time.  Some asset classes can also increase your overall risk, so a little knowledge can go a long way towards understanding your choices.  There are a lot of asset classes to choose from, and each carries its own costs and behaviors.  If you’re not sure what to choose or what amounts to place into each asset class, it’s time to meet with an advisor.  Be willing to learn, never be afraid to ask questions, and once again remember that for most of us it’s time, not timing, that makes the biggest difference.  

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