Welcome to Week 3 of our 7 part educational series on investments and investing concepts.
Last week, we covered the fundamentals of the 4 Most Common Investment Vehicles we see in our investment accounts.
If you’re just joining us for the first time, you can catch up on the first couple of blogs at the links below:
- Why We Invest? Read by clicking here.
- 4 Common Investment Choices. Read by clicking here.
This week, we are going to dive deeper into what role they play inside of our investment accounts, and how they contribute to the overall growth we see over the period of time we hold them.
While growth (investment return) is important, one of the most overlooked and stress-inducing pieces of the investment process is the risk we accept when looking to achieve growth.
Risk is a word that many of us don’t like to think about, or hear when we are partaking in an activity. It usually comes with a negative connotation attached to the thought of something bad happening.
No different than jumping out of an airplane, when we take the leap to make an investment, the hardest part to overcome is the thought of it all coming crashing down. Thankfully for skydivers, a parachute is much more reliable than predicting the near future of the stock market.
I say “near future” of the stock market only because we have enough historical data to make reasonable assumptions about what we can expect over a longer investment period.
This also does not mean I know what is going to happen 1, 5, 20, or even 100 years from now. Please consult with your financial advisor or other investment professionals before making any investments. This article is not advice or intended to serve as a recommendation of any particular investment or investment strategy.
Many considerations go into developing a risk profile when looking at investments to choose from. As we talked about in Week 1 of our series, it all starts with why we invest.
To summarize the key points of the different goals mentioned in the earlier blog post, here is what we need to determine before making an investment choice:
- How much are we able to invest, and how much will we need for the goal?
- Will we be investing a lump sum, or making consistent deposits into our investment account?
- When do we need the money for use towards our goal(s)? To add to this, will we need all of the money at once, or over a period of time?
While those questions help us select the investments we will ultimately use, they are also foundational questions in helping us determine the risk we will take with the investments.
To generalize, the more potential return we expect from an investment, the more risk we will be taking on. This isn’t always the case, but for our illustrative purposes, we are going to look more at the theoretical application of the risk versus reward matrix.
Simply put, we should hope to be compensated for the risk we are taking.
This concept of risk is prevalent in so many areas of our financial life. Our jobs, our credit and the cost of money we borrow, insurances, and even forms of entertainment like gambling or adrenaline sports illustrate this concept. The list goes on and on.
The bigger risk you take, the more you have to gain or lose. This is no different from investing.
Smaller, newer companies usually have a lower chance of becoming a large, successful company. Larger companies likely won’t grow to the degree a smaller company will, but also won’t be as impacted (in most cases, anyways) as much as a small company would be given a particular event occurring.
You’ve surely heard about large companies that were once just a few dollars per share, and now are worth hundreds or thousands of dollars per share. Success stories to this degree are few and far between. We will come back to this in just a minute.
Before we answer the original questions posed at the beginning of the blog, let’s look back at the asset classes from last week.
The graphic below illustrates a few common indexes we track in the investment world.
- S&P 500: The 500 largest companies (by value) in the United States.
- Russell 2000: The 2000 smallest companies of the largest 3,000 companies in the U.S. stock market. I know… how confusing of a description is this?
- S&P U.S. Aggregate Bond Index: An aggregate of the U.S. Investment Grade debt (bonds).
As we learned last week, stocks and bonds are very different forms of investing in a company. Bonds have a higher degree of certainty as to what we can expect the return of our investment to be than stocks do, and this is shown with the degree of value change in the chart above.
Going deeper into the stock category, we can see that the Russell 2000 Index (smaller companies) experienced greater highs and lows with steeper change than the S&P 500 Index (larger companies) did in the same time frame.
This explains the statement made above. Smaller companies are less established and therefore are at a higher risk of going out of business than larger companies.
A great way to think about this is thinking about your local diner in your town with one location versus a chain restaurant with hundreds or even thousands of locations. If something happens in your hometown that impacts the number of customers your diner has, it is going to be far more affected than if a large chain loses business from one of its several locations.
On the flip side, if you invested in your local diner (again… not a recommendation) and it became a large chain, your payoff would be far greater than if you were to invest in a larger chain that adds an equal amount of locations. Risk is greater, but the reward is greater, too.
This is what we are seeing play out inside of the graphic and it is a key piece to understanding your risk tolerance.
The return side of the equation is important to understand as well because it can influence how fast we will get to our goal.
To answer a couple of the questions from before…
Is the goal you have time-sensitive? Do you need the money all at once?
If so, you probably won’t be as comfortable with the ups and downs, especially the big downs like we saw in March 2020. The closer we get to a goal, the fewer ups and downs we will be willing to tolerate.
Should the money all be needed at once, this will be especially true.
If you were saving for a down payment on a house next year, for example, you wouldn’t want to be in a situation where you found the house you want, and then have your down payment be 5%, 10% or 30% less than what you needed because of a down market.
This leads us to the next point of today. We don’t need to (and probably shouldn’t) go all-in on one single company or even a single type of company.
As we learned last week in our blog about asset classes (read it here), the fewer investments we hold, the more specific risks we are subject to based on the traits of the investment.
To avoid this, we need to consider multiple assets of the same class, and also multiple classes of assets.
Last week, we briefly spoke about how Mutual Funds package multiple companies or investments into one, easy-to-purchase package which is again illustrated below.
While sharing in the gains and losses of two companies is a good start, sharing in hundreds or thousands from all different areas of the world and asset classes is even better.
Why is that you may ask?
Look at this chart below, which illustrates the performance of the major asset classes we typically see in a globally diversified portfolio.
As you will see, it is very difficult to predict which asset class will be at the top in a given year, and there really is no rhyme or reason as to the order in which the assets will be at the top.
There may be trends, but we still won’t know for certain.
Having a mix of these assets will reduce the chance of having to rely on any particular asset class to provide the growth we need to achieve our goals.
Having a diversified portfolio allows us to smooth out the big swings we see from our investment’s performance in a given year. This isn’t to say we won’t have a down year from time to time, but rather that we won’t experience the “all or nothing” highs and lows.
I am sure we have all heard the success and failure stories in the news.
You will also notice in the graphic above, that not all investment classes move to the same degree. This is a very important concept to understand when investing.
If some of our assets are down 10%, 20%, or 30% in a given year, we don’t want to sell off those investments (in most cases), but rather want to be able to weather the storm and wait for their value to return to the positive side of the equation.
As you can see in the chart below, the greater degree of equities (stocks) we have in a portfolio, the more volatile the value of our investment account will be. The key thing to remember here is not all holdings in the portfolio will be up/down the same amount at any given time.
Even by reducing our portfolio from 100% Stocks, 0% Bonds to 75% Stocks, 25% Bonds can smooth out the ups and downs we will see in our portfolio over time.
This does come with the tradeoff of a lower expected amount of growth, however. This goes back to being compensated for the amount of risk we take.
This is further illustrated in the chart below, which shows the individual movement of investments and how they smooth out when combined with each other versus being held individually.
We can have winners and losers at any given moment, but it becomes an average, which is more easily projected over the long term.
With all of the pieces of our investment account not moving in the same direction, or at the same rate, this can cause our investment assets to be out of line with our risk tolerance over time.
We will talk more about this next week when we talk about rebalancing, and why it is important to visit on a regular basis. Subscribe below!
Determining the risk you are willing to take will come down to how you answer the questions at the beginning of this article, but it also will need to account for your general outlook on the money you are putting aside.
If you are going to lose sleep when seeing the account go up and down frequently, not knowing what it will be tomorrow, a high-risk, high-return investment allocation probably isn’t the right choice for you.
On the flip side, if you aren’t worried about the money until you need it 40-years from now, it could pay to be invested a bit more aggressively.
Again, I can’t stress it enough, but please consult with your financial advisor or other financial professionals before making investment choices. This article is not investment advice.
The right answer is what is right for you, and understanding you can still achieve your goals either way is important. You just may need a bit more time.
Next week, we will cover rebalancing, and how the topics we have covered so far factor into why it is so important. We have the foundations in place from the last few weeks of material.
We know the answer to… Why do we invest?
We know about the 4 Common Investment Choices.
We now have a better understanding of the role risk plays in our investment choices, and next week we are going to cover how we maintain that risk and the investment’s objective over time.
If you want some help going through this process for your own investment portfolio, you can schedule a 30-minute Free Consultation by clicking the button below.
Until next time,