Investing Basics – Risk vs. Reward

In 2005, people spent 125% of what they made. They spent money they had not earned yet so they built up debt and paid interest on that debt every month. If you spent less than you made than you actually were paid interest on your money, just the opposite. The return you can expect from that hard earned money greatly depends on the level of risk associated to it. No risk does not equal any reward however; risk is not a big scary animal we all run from.

The first thing to decide is how much money you want your investments to make. It could be from 1% to 30% and everything in between. One percent return is incredibly low but very safe. Actually, 100% safe since that is what your savings account is paying. If you think that you are making money in your savings account than you forgot to think about inflation. Let’s assume that inflation is around 3% a year. If your investments are making 3%, you broke even. You did not make a dime because inflation took 3% of the buying power your money had a year ago away. $100 today is only worth $97 in one year. If you investment made 3%, which is $3, you are back at $100. Take 3% off your return and that is your real return.

If you want a high return than do not expect to be risk averse. The higher the reward the higher the risk you need to consider. Bonds currently are sitting around 5%. This is a safe 5% and you will not lose that money. Once you consider inflation, it suddenly turns into gas money. Stocks have beaten every other investment in any 20 year period. Stocks make most cringe but there are many ways to enjoy the rewards of the stock market without worrying that you are losing your children’s college fund. You can buy an index fund that invests in the S&P 500 or the Dow Jones. The S&P 500 is 500 companies if you invested $500, $1 would be in every single company. The S&P makes around 10% a year. There is a very slim chance the S&P would go to zero although there are correction years. That is why you need to invest long term. If you start buying in one of those correct years, you will lose money but think long term and you will realize to buy heavy in those correction years. Buy low and sell high is the game but many of us do it the opposite way.

When investing, not only is risk and reward important, but also your age. This may be new to you but age is very important to investing. Age tells us what level of risk we should expect. If you are in you 20s, you should be investing in the highest risk funds possible. The reason is that a person has longer to replace that money if he loses it all. A senior citizen does not have those years and the advice is just the opposite. Little to no risk and invest in only fixed income which is bonds and CDs and 100% safe alternatives. The older you get the less risk you should be allowing. 10% fixed income for every decade you are old is a general rule. Do the math and determine your risk level.

There are many safe investments out there but as the saying goes, “no pain, no gain”. The reward for “the pain” is the 10% and upwards return you could enjoy.