Critical Factors: Investing Risk and Reward

So, I was in an eclectic coffee shop with my 26-year old daughter over the holidays last year. One of the traditions of this coffee shop is that all the cups and mugs are from thrift stores- stuff that they’re accumulated over the years. The two guys working the shop were in their 20s, also. My daughter had a short conversation with one of the guys, who bought her coffee over. Here’s what the coffee mug said:

“Hold me, touch me, love me”

Hey- it’s worth a try right? Maybe the girl thinks it’s cute and ends up starting the conversation again. The shopkeeper took a risk (picking the mug) and hoped for a reward (cute girl talks to him).

Well, I think she’s cute, but I’m biased.

Which brings us to this topic: critical factors regarding investment risks and rewards.

Separating secure and profitable

Like many questions, the answer here is “it depends”, because there’s always a balance of risk (security) and reward (profitability). As I’ll explain below, the degree to which people are comfortable with risk can vary greatly.

Skydiving and bungee jumping

Patton Oswalt has a great line in his latest standup routine on Netflix. He describes someone who just lands after skydiving and a friend asks: “Let’s go bungee jumping!” You’re probably jacked up after skydiving for the first time- and you can’t possibly do another risky event right away.

But some people do.

If you’re willing to take huge risks in exchange for a potential large payoff, try angel investing.  Angel investors provide funds to early stage startup companies, and they’re willing to lose money on the majority of their investments in the hopes that they hit a home run.

One of the most successful high-risk investors is Peter Thiel, who made a $500,000 investment into Facebook very early, and netted over a billion dollars from the investment. The Social Network movie touches on his investment.

So, there’s your “go big or go home” profitable investment.

Why sticking money in your mattress doesn’t pay off

Now, you may think that the other choice (ultra secure) would be stick your money in a mattress, but there are some problems with that strategy. If you don’t earn a return on your funds, you lose purchasing power due to inflation. So, the idea is to manage risk and still earn a rate of return.

Instead, try a low-cost stock index fund. These funds are portfolios of common stock designed to mirror the performance of a stock index, such as the Standard and Poor’s (S&P) 500 index.

These funds are less expensive to manage, because the money manager just makes the same buy and sell decisions as dictated by the index. If, for example, the stock index lowers the percentage investment in IBM common stock to 1.5% of the total portfolio, the index fund makes the same adjustment.

The average annual return for the S&P 500 index is around 7-8% for the past 70+ years, depending on if you reinvest your earnings and other factors. As you’ll see in this year-by-year listing, the ride can be bumpy. But, if you’re willing to invest for the long term, a low-cost S&P 500 index fund can be fairly secure and profitable.

How Do I Judge Risk?

This question remains one of the toughest to assess, and the question applies to investors and financial services professionals who counsel investors. Without taking the time to answer this question, you’ll invest in financial products that aren’t suitable- and you won’t sleep at night.

How do I know this?

Monthly investment statements.

How many people do you know who didn’t read their investment statements during a market downturn? More than a few, probably. These people don’t truly understand their own tolerance for risk. When the market is down 20%, a certain percentage of investors will panic- and not read their investment statements.

It’s the same reason why people don’t go to the doctor- the risk of bad news.

Ask Yourself

So ask yourself: If the broad stock market declined 10% in a year, is that something you could live with? How about 20%…30%? Bear in mind that tolerating more downside risk means more potential rewards on the upside.

Assess your personal risk tolerance, to gain some investing peace of mind.