Summary: Should an investor worry about the level of risk that they take? Should they use safe investing strategies or low risk investments? Just how secure are most investments? This page discusses the options.
Understanding the concept of investment risk is one of the key skills that separates the professional investor from the amateur. Having met many fund managers and traders, your author can attest to this fact.
The amateur investor (more details here) wants 'tips' - details about individual companies that may be worth investing in. While the focus on a fast profit is understandable, there is usually very little understanding of how this company might fit into the rest of a portfolio.
In contrast, a professional investor or trader gets 'tips' all the time from people trying to sell analytic or trading services. For them, it is a real job to avoid all these tips and salesmen! Therefore, the professional is often focused on the amount of risk being taken with money and whether there are better opportunities available elsewhere for similar amounts of risk. Confused?
This is all in the stock market though.
It is worth remembering, even for a website about the stock market (more details here), that there are many other potential ways to invest money. Some are potentially very risky. Some are much safer.
It is also worth remembering that most investments that might be considered to be 'low risk' also offer lower potential returns.
Why Do People Use Low Risk Investments?
If the potential return is low, why do people like them?
The reality is that for virtually every private investor and family in the world, money is finite. Their ability to earn more has some limits - apart perhaps from oil sheiks and Russian oligarchs - and therefore, it is unwise to have all of their money or net worth tied up in high risk, illiquid investments. Some money needs to be available in case of an emergency.
In financial planning, this is known as an emergency fund and would normally relate to a number of months of income set aside in a bank account that has instant access.
There
are many forms of saving that use a traditional bank account for 'cash'
holdings. But there are many other types of method of safe investing
(for example, corporate and government bonds and money market accounts). These secure investments really ought to provide the foundation upon which a portfolio can be built.
As well as a general need to take lower risks with some money, many people are simply not comfortable taking too much risk. This is understandable and may relate to the difficulty in earning money or the value that they place upon it. Either way, for these people that find the mere idea of losing money to be stressful, the stock market and other high risk assets should be avoided.
There may be some assets that are on a stock exchange and meet the low risk criteria, but these would probably take the form of mutual funds or unit trusts (to help diversify risk) and would be in a very, very low risk fund. Even the most low risk stocks might prove to be too adventurous for this money.
It is interesting to note though, that many people who are typically low risk or even very risk averse do not seem to find buying a residential property to be risky. There are many reasons for a house to become a family home and much more than an investment, but when looked at coldly as an investment, many houses are very high risk. This is because of the potential lack of liquidity, the high amounts of borrowing required to purchase and the value of the property relative the average annual wage of the buyers.
To quote a very experienced investor friend, "Property is very lumpy". This is his way of explaining that for most people adding a property to your overall portfolio skews it dramatically and ties up what would likely be a very large portion of capital which, as mentioned above, might be hard to realise because of the inherent liquidity issues surrounding property. In laymans terms, you cannot generally just sell 10% of a house to lower your exposure - you own all or none of it.
Therefore, there are both financial and emotional reasons for using low risk investing strategies. Hopefully it goes without saying that low risk investing returns tend to be similar, or perhaps a little better, than that of a bank account. Generally, these investing strategies have much less volatility than other concepts and are easy to "make ready" or access at short(ish) notice.
What Are The Best Methods Of Safe Investing?
For the vast majority of people in the developed world, the best investment that they can make (low or high risk) is in making additional repayments on their debts.
The reality is that most of us owe
too much money and at some point - preferably before either death or
retirement - it will have to be repaid. Until that day, it is a weight
hanging around our necks and requiring some or all of our monthly
income. For some people this kind of regular financial burden is similar to modern day slavery. This seems a little hardcore to think of, but the parallels are clear.
Money in the bank in an average savings account will almost always earn less in interest than is charged on loans. This is because banks make much of their money and profit by charging more to borrow money than they pay to savers.
In addition, many credit and store cards charge over 15 percent above the rate a saver would earn. Any investment professional will tell you that it is difficult to make an annual return of more than around 8% consistently. Therefore, any debt with a rate of perhaps 18-25 percent per year is a very heavy weight to carry.
Financially, most of us will never in our lives make an investment that returns more than is charged by a credit card. Repaying them should be a high priority.
Admittedly, repaying a debt is not very fun, adventurous or glamorous. We know. But it is a very sound financial strategy to follow.
To answer the rather provocative question at the top of this page, the point of safe investing is that it can actually be more profitable (in the savings made) than many forms of higher risk investment.
If on the other hand you are not encumbered by debts, then what?
Money market accounts and CDs (certificates of deposit) are be steady low risk places to park money. Even these can have their risks, if the company offering the products gets into trouble for example. While this may seem a little esoteric, the eurozone crisis has shown just how weak and vulnerable many of Europe's leading banks are / were. The risks of a bank "going under" are not so slight in the modern world. Thus, there is probably no such thing as fail safe investing.
For Americans, T-Bills (government debt) is considered to be the risk free rate of return for money, but with the American debt position as it is, the words "risk free" seem a little generous.
The best advice we can offer is to diversify. Do not keep all of your assets in any one location or type of holding. by keeping a number of pots warm you will hopefully not go hungry.
Lessons From The Eurozone
However, there can be times when this is very difficult advice to follow. At the time of updating this page in early 2013, the eurozone crisis seems to be well underway again. There are a number of major economies that are struggling (Italy, France and the UK, for example) and a number of other economies that are almost certainly in outright depression (Greece, Portugal and Spain, for example) and two economies (Spain and Cyprus) where the entire banking system is in trouble. Needless to say, in such times the stock market seems to be quite risky.
Yet, these economies have weaknesses within their banking sectors, which is a major part of the problem, suggesting that money held on deposit in the bank may or may not be safe. Add in problems with government debt repayments and another of the more traditional safe havens for capital looks quite risky.
Under such conditions, it could be argued that even cash has it's risks (after all, the existence of the currency may ultimately be at stake) meaning that there are few, if any, obvious places for low risk investing and few truly secure investments.
Typically, in times of trouble, precious metals such as gold and silver have been considered to be "real money" and more than commodities. Yet their prices have failed to ignite despite the massive creation of money by the European Central Bank (and many other central banks) since the 2008 banking crisis began. As inflation has failed to set in, the confidence in metals has waned a little.
Thus, where to store capital for safety in times of trouble offers a perplexing puzzle and for amateurs and professionals aline, the hunt for the most secure investments continues.
To read more, please follow these links:
Beginners Guide To Investing
What Different Ways Of Investing Money Are There?
How Does Investing In Rental Properties Compare To The Stock Market?
Should You Be Concerned By Currency Exchange Risk?