By Chris Borg
So what exactly is risk and reward? In life there are many risks one must take. Crossing the street is a risk. Fortunately, most of the time, one can control that risk. You look both ways before crossing the street. The same holds true for investing. Investing has inherent risks but here again, one can (to a limited extent) control the risk. Your financial freedom is closely tied to how much risk you take on as it will determine how much reward you will garner from your investments. It all boils down to what some people call "the sleep factor". How well do you like to sleep at night?Do you like not worrying about your investments which in turn will allow you to sleep better? Or are you the aggressive type that wants to shoot for the stars with your investments which could cause you to miss a night or two of sleep? You need to choose your tolerance for risk and reward. In the financial world this is known as a person's risk tolerance. How well do you tolerate risk. When you open up a retirement account or a brokerage account to start investing, you will be filling out an application that contains many questions some of which will be aimed at determining your risk tolerance and some will be aimed at determining your time horizon. In other words, what are you comfortable investing in and when do you need to have the money back in order to meet some of life's necessities and obligations like buying a house, sending kids to college or retiring.
As a newbie investor, you are probably familiar with the interest you earn on your savings account, which at the time of this writing is less than 1% annually. This is an example of low risk-reward. Furthermore the bank in which you have the savings account probably offers you FDIC Insurance (Federal Deposit Insurance Corporation ) on the account. This insurance which used to cover up to $100,000.00 per depositor was recently increased to $250,000.00 per account and will stay at that level until Jan 1, 2014 at which time it is scheduled to reset back to $100,000.00 per account with the exception of some retirement accounts that will remain at the $250K limit. Having that insurance is one of the ways you can control risk. If the bank fails, the FDIC will reimburse you.
Now if you think 1% interest is low, just imagine what you might think when you find out that the interest is subject to taxes so after you pay taxes to Uncle Sam on the 1% you earned, you will wind up with approximately.66% interest! If you want to earn more interest, you might consider moving some of your money into a bank CD (Certificate of Deposit). The bank will give you a little bit more interest in exchange for you not touching the money for a set period of time. Right now 1 year CD's are just a tick over 1% and 5 year CD's are hovering around 2%. If you need your money back before 1 year or 5 years, you will forfeit some of the interest as a penalty. Once again, the interest is subject to taxes. By now you should start to see that taking on low risk will mean little reward for your efforts with a subsequent longer time period before you reach financial freedom.
So now you start to feel that these are pretty lousy interest rates and you begin to look around for a better way to invest your money. What you will find out is that most of the products that you can invest in do not come with FDIC insurance. This means that if you want to invest in them to get a better interest rate of return, you will have to understand that you could possibly lose money. How much money can you lose? That depends on what you are investing in but basically it is a pretty linear relationship meaning, the more reward (interest) you seek, the more risk you have to take...a.k.a. high risk-reward. If you learn to invest successfully your high rewards will bring you financial freedom that much sooner! Here is a very simple list to better explain this relationship. Interest rate shown is approximate for that class of securities as the rates are constantly changing and it is shown on an annualized basis.
Securities Class Annualized Percentage Return
Bonds:
Treasury 5 year: 2.65%, 10 year: 3.75%, 30 year: 4.5%
Municipal 3.5% to 5%
Corporates 6% to 8%
Mutual Funds 9%
Stocks 10% to 12%
Annuities:
Fixed 4%
Variable 7%
Commodities/Forex/Options: very high interest if done right...20% and more is very common.
To invest in any of the above securities and many more unmentioned ones, you will need to open a brokerage account. While there is no FDIC Insurance, you will usually get S.I.P.C. Insurance (Securities Investor Protection Corporation). This does not protect you against loss of your money if the securities were to decrease in market value. The protection kicks in where there is a case of brokerage house failure or bankruptcy. Coverage is up to $500,000.00 for covered securities and $100,000.00 for cash. The value of the above mentioned securities will fluctuate daily with the activity of the market so it is entirely possible that you can lose money if you decide to cash out at the wrong time. If you are willing to take this risk than you will be compensated with a better interest rate of return than the minuscule 1% to 2% you would normally get on a savings or C.D. account.
As you move up the scale of risk and reward, you will be taking a much greater chance of losing your money!!!
Now that you understand the danger of seeking out more reward, don't let it stop you from doing so. In life sometimes you need to take some risk to get ahead and reach true financial freedom. Investing in the stock market can be risky but the way to soften all the bumps that you will encounter is to diversify among asset classes and to have a long time horizon. That's easy to do if you are saving for retirement but maybe not so easy if you need the money sooner such as buying a house. A rule of thumb here is that if you need the money in 3 years or less, you should not be invested in stocks as a severe market correction (read decline) will be very difficult to overcome in 3 years or less. Also keep in mind that over the past 70 to 80 years, the stock market has averaged an approximate 10% rate of return.
The Risk and Reward relationship is understood very well by those who work on Wall Street but not so well by the average lay person. If you need proof of this, just keep an eye out for all the scams you see in the newspapers and on T.V. People get lured in all the time with the promise of high returns. The guiding maxim here is "If it seems too good to be true, then it generally is".
To summarize, the following is the order of investments from lowest risk and lowest reward to a higher risk and higher reward. The more risk you take on, the more reward you can expect to capture and the sooner you should be able to reach financial freedom:
Savings account are less risk-reward than bank c.d.'s which is less risk-reward than treasury bonds which is less risk-reward than municipal bonds which is less risk-reward than corporate bonds which is less risk-reward than mutual funds which is less risk-reward than individual stocks which is less risk-reward than stock options.
Chris Borg is a practicing pharmacist and financial adviser who writes about health care and investing. Chris's latest website on financial freedom is at RatraceBgone, where Chris provides financial tips such as the 9 steps to financial freedom: 9 Steps To Financial Freedom
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