Of all the potential investment mistakes — and there are a lot of them — two of the most common are taking on either too much or too little investment risk. To invest successfully, you need to avoid both of these problems.
For starters, you need to be aware that investing always involves some type of risk. When you invest in stocks, and they lose value, you could lose some of your principal. On the other hand, if you purchase investments that are often thought of as “risk-free,” such as U.S. Government Securities, you could lose purchasing power if your fixed rate of return doesn’t keep up with inflation.
In short, you’ll need to find a balance between taking “too much” and “too little” risk. Let’s look at both sides of the issue.
Too much risk
Many people are aware that higher investment returns are related to higher risk, but they somehow feel that they simply won’t sustain losses, or that they’ll supernaturally know the “right” moment in which to sell. The fact is, however, that no one is immune from losses — and nobody can predict the exact moment that’s best for selling. To keep yourself from taking on too much investment risk, consider the following guidelines:
• Know yourself: Make sure you’re familiar with your own investment personality. If you know that you really like to invest aggressively, you may need to “rein yourself in” on occasion, especially if you’re considering “hot” investments, whose recent track record may not be supported by solid fundamentals.
• Know what could go wrong with an investment: Before you buy, you need to understand what could go wrong with an investment. For example, if you’re buying a stock, you need to realize that the company management could change, or the company’s products could become noncompetitive. At the same time, you might want to develop an “exit strategy” for getting out of this stock, in case your “worst-case” scenario comes true.
Too little risk
If you’re susceptible to taking too little investment risk, you may want to act on these suggestions:
• Know your time horizon: Many people are frightened away from stocks because of their short-term volatility. And it’s certainly true that on a daily, monthly or even yearly basis, stock prices will move up and down. However, for the past seven decades, stocks have always trended up. In fact, from the beginning of 1926 through the end of 2002, the S & P 500 index (this is an unmanaged index and may not be invested into directly) showed a compound annual growth rate of 10.2 percent. So, if you have many years to go until retirement, you should have enough time to “ride out” the ups and downs of the market. As you near retirement, you may want to lower your investment risk somewhat by moving some dollars out of stocks and into fixed-income vehicles — but, even during retirement, you may need to consider some growth elements in your portfolio.
• Know what your goals will cost: You can probably identify your long-term goals — a comfortable retirement, college for your kids, etc. But do you know how much they’ll cost? Once you put a “price tag” on your goals, you’ll quickly see that a “low-risk” investment strategy — heavy on Certificates of Deposit, bonds and money market accounts — may not provide the growth you need. Consequently, you can see the importance of adding stocks to the mix.
Ultimately, you must balance low-risk and high-risk investments according to your personal risk tolerance, your long-term goals and your time horizon. In the end, you don’t want high risk or low risk — you want intelligent risk.
Scott Flake is a licensed financial adviser with the firm of Edward Jones. He hosts a weekly informal investment discussion on Tuesdays at 10 a.m. at his office at 411 S. Beeline Highway, Suite B. For more information, call him at (928) 468-1470.