Investment Risks

Health risks, travel risks, relationship risks, business risks.  The list of risks is almost endless.  The same might be said for investing. But don’t let that fact grow fangs and put you in a panic such that you steer clear of investing altogether.  Instead, just be armed with knowledge.  Here’s the context for what we’ll learn in this chapter:

The key to minimizing your investment risk is:

1. Know clearly what risks are involved, and

2. Eliminate those risks that you can, mitigate those that you can, and manage the rest.

So, what are the specific risks that you need to be aware of? Let’s walk through them.The risk that most people think of first when they think of investing is stock market risk.  Of course, this risk only applies to an investment in the stock market such as a bond, stock, mutual fund, or variable annuity. If you are not investing in the stock market, your money will not be exposed to market risk.

Another risk that a lot of people rightly worry about is liquidity risk. This risk is associated with an inability to get your money out quickly and without penalty.  A bank savings account can be said to have no liquidity risk, because you can stop by any branch at any time that the bank is open (which, by the way, is not often enough, in my opinion, but I digress …).  On the other hand if you were to purchase an interest in an oil drilling program you would most certainly encounter the full brunt of liquidity risk if you called the issuer and said,

“Hello, my name is John Smith and I invested $25,000 with you eight months ago and I’ve decided I want my money back.  Will you please wire me my money today?    

“You want what?” is the response you would hear right before the receptionist’s hand went over the phone. 

She would turn to the office and say,“Hey, guys, you’re not going to believe this!  Some investor just called and says he wants us to wire him his money back.”

Opportunity risk

This one does have fangs.

Suppose that you are retiring at 65 and want to rely on your 401(k) nest egg to provide a comfortable retirement for you.  Further, you have decided that you need $3,000 a month in income from your nest egg.  However, you have also decided that, unlike a lot of your friends, you are not going to be so foolish as to invest your money in anything that is risky.  Nope.  You are smart.  It’ll be banks and the FDIC insurance they offer for you.

You start with $300,000 in your 401(k), which you transferred to an IRA at your bank and invested at an interest rate of 5%.  (Heck, you even got a free toaster just for doing the right thing.  And wasn’t that branch manager a nice fellow, just the kind of professional you knew you deserved.)

Your first month goes great.  Sure enough, the $3,000 check comes on time, right to your mailbox.  Same thing the following month.  In fact, you laugh at the headlines of the newspaper when you read six months into your retirement: “Stock Market Loses 500 Points In One Day!”

Ha!  Not of any concern to you.  You are smart.  Life is good.  At least until you walk out to your mailbox early in the eleventh year of your dream retirement life.  No check. Hmm.  That’s strange.  And last month’s check wasn’t for the full $3,000, either.  A bead of sweat builds on your forehead.

“No, Mr. Smart, there is no error,” Mr. Banker says.  “We paid your account 5% interest annually and you withdrew $3,000 a month. Now, your account is closed.  There is no more money in it.”

Sounds implausible, doesn’t it?  Unfortunately, opportunity risk lulls people into complacency all too often, and many times to a point of no return.

Now Mr. Dummo, on the other hand, decided to split his investments into four different types, each with a different level of overall risk.  The first one was a money market fund for $75,000.  The second investment achieved a 4% return for 25 months, which produced a little more than $81,000. He turned that into an investment of 6% and used it over the next 9 months to pay his $3,000 monthly retirement incomes.  His third cache of $75,000 he invested for the next 54 months and received a 12% return, which created a balance of $128,355.   He then re-invested that amount into another investment that produced 6%, and received his required $3,000 monthly income for the next 48 months until that account was consumed.  This left his last investment of $75,000, which he had been able to achieve a 15% return on.  After 102 months at a return of 15%, the original $75,000 had grown to $266,289.  With this account, he decided to invest in a diversified portfolio that was able to achieve a 12% return each year. 

With this scenario, Mr. Dummo was able to keep his monthly income of $3,000 a month intact for a total of 321 months, or almost 27 years.  Remember, Mr. Smart’s $3,000 monthly income stopped after just over 10 years.

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