Safety vs. Returns in Investing
Listen, we get it: with the roller coaster nightmare that was 2020 (and the hungover daze that is 2021) you would be totally justified in not wanting risk anywhere near your money. It’s a trend carried over a lifetime for Millennial investors, who are more risk-averse due to the turbulence in their lives (9/11 and the Great Recession, to name a few) and more willing to trust themselves than the financial system.
There’s just one problem: in investing, risk and reward often go hand-in-hand.
How do you strike the balance between investing safety and investing gains? Here’s what investors should know.
Investing Safety or Risk?
The link between risk and return isn’t just a saying among financial experts. It’s a statistically observed phenomenon—risk and return have been shown to be highly correlated. Unfortunately, all investing comes with some form of risk.
In fact, the whole concept of investment returns is tied up in risk. Return on investment is considered a random variable taking any value within a given range, often influenced by risk.
Now, to be clear, just because you take a big risk doesn’t mean it’s going to pay off. That’s why it’s risky. Keep in mind that risk and return are also correlated in part because investing a larger amount of money (which is necessary to see higher gains) also qualifies as a risk in itself, never mind the risk attached to the venture you invested in.
Every investment has its own associated risk, and some investments are riskier than others. As a rule, the lower risk the investment, the better chance of seeing returns, but the lower the returns will be. Think about a government bond, a type of debt security issued by the government. Essentially, you pay the government a loan in exchange for the principal and interest after a fixed period of time. That return is pretty much guaranteed, which means it’s not profitable for the government to offer huge payouts—otherwise, it cancels the value of the money they borrowed.
The Risk vs. Returns Calculus
For investors, safety versus returns is an important consideration throughout the lifetime of your portfolio, and not just for personal preference. Risk exposure carries the potential for growth, but also the potential for losing everything you invested, or staying exactly where you started. The more risk exposure your whole portfolio has, the more risk you have of losing your money.
This is critical as you approach the time when you need your money. Basically, the sooner you need your money, the less risk you can afford to take with it. For example, if you know you’re going to need your money in three months and invest it, only to realize in three months that you haven’t recouped the money yet, you’re going to be in trouble.
On the other hand, there are some expenditures that are so large that you can’t possibly afford them without growing your money. Retirement is a great example of this. Fidelity estimates that you should have at least 10 times your salary socked away for retirement by age 67. Unless you never take on debts, never send a kid to college, never have any major medical issues, and save every red penny you ever earn, that’s impossible without investing.
When You Need Safe Investments
The key is to strike a balance between safe investments and risky investments. So, all other things equal, let’s take a look at when you need safe investments—and when you can afford some risk.
Let’s assume your primary investment concern is retirement. In this case, younger investors can afford to take more risks than older ones. Assuming retirement happens at 67, a 24-year-old has 43 years to recoup losses and grow their money. A 44-year-old, on the other hand, only has 23 years, and a 64-year-old is more concerned with planning for oncoming retirement.
As a rule, safer investments are more concerned with preservation of capital than growth. In other words, you’re more concerned with preventing losses than creating gains. This strategy is most appropriate for those who need their investments in a relatively short window of time, which for investing means anything less than five to ten years.
For a retiree, that means gradually adopting safer investments to protect the capital you already have as you near retirement. That way, you won’t risk losing precious dollars when you lose your salary.
When You Can Afford Risk
That said, safer options don’t grow your money that much. After all, your money isn’t exposed to as many opportunities to grow. And there are times when you need to take risks so that your money can grow.
The longer your investment lifespan, the more risk you can afford to take. Basically, the more time you have to recover losses, the more leeway you have to try different strategies. After all, at this point, your primary goal is to grow your portfolio.
Again, this means that younger investors can afford to take more risks than older ones. For example, you can afford to invest in a riskier growth strategy when you’re young because you have decades to recover if it doesn’t pan out.
What if You Want to Moderate Risk?
Now, let’s say you want to take risks but moderate the potential fallout. The good news is that there’s a strategy to do this, one that every investor should use: diversification.
All investments come with risk. However, if you spread risk out across multiple investments, you dilute the risk over your entire portfolio. That way, if any individual investment falls apart, your whole portfolio won’t vanish with it.