Is there such a thing as a safe investment? No, investing is not safe, but are there prudent investing practices?
Is there such thing as a safe investment? If you’re like the typical investor, you’ve spent some time pondering this question. You probably came to the realization that safe investments don’t exist, but some investments may be relatively less risky than others.
But perhaps you discovered something else: that perhaps you acquired these “lower-risk” investments due more to your investment practices—i.e., how you invest—than to the assets themselves. In other words, how you allocate your assets, how you diversify your portfolio, and how you manage the potential risks and returns may be what ultimately determines each investment’s relative degree of risk and overall performance. If you came to this conclusion, you’re probably right.
An advice columnist used to say, “Want to double your money quick? Fold it in half and put it in your pocket.” In other words, by not losing money, you are immediately ahead of where you would be had you lost it. The joke is meant to warn against taking foolish or excessive financial risks.
But might this advice hold some truth? If, in search of safe investments, you were to park your money in a bank account or simply stash it under the mattress, would your money be sheltered from risk or loss? Wouldn’t inflation eat away at your purchasing power over time? Almost certainly it would, which tells you that even the most stringent capital preservation—keeping it under lock and key—would likely offer no immunity to real risk or loss.
The familiar saying “no pain, no gain” could be adapted for investing as, “no risk, no return.” Well, it’s still a vague half-truth. Here’s a clearer way to look at it:
In other words, it’s no easy feat to find low-risk investments with high returns; there’s typically a tradeoff. This invites the next question: what investing practices can minimize your risks while maximizing your potential returns?
Although this question can lead you into highly complex and theoretical territory, let’s avoid all the theory for now and settle on a few basic principles, a few rules of thumb, and practical bits of common investing wisdom.
1. Strategically Apportioning Your Assets
Asset allocation refers to the percentages of your total portfolio holdings that you place into stocks, bonds, and cash. Sounds simple? In principle, yes. In practice, however, apportioning your assets to match your investing goals, risk tolerance, and time horizon requires time, thought, and effort. Asset allocation may be the most fundamental, strategic, and perhaps important part of your investing process.
So, allocate your assets carefully. You’re laying the foundation for every other investment decision you subsequently make.
2. Don’t Put All Your Eggs in One Basket
In a nutshell, this is what diversification is all about. When the market turns down, the various parts that make up the broader market—from industries and sectors to individual companies—may react differently. Some may experience sharp declines, while others may not decline at all, or may even rise. This points to the idea that various individual components of the broader market may behave differently in relation to one another depending on market conditions.
Diversification is about selecting assets that won’t all move in the same direction when negative market conditions occur. It allows you to spread your risk across different types of assets, avoiding the risk of placing all of your eggs in one basket. The assets you select—whether stocks or bonds—may move in different directions when exposed to factors that negatively affect the broader market.
3. Plan for the Long Term
We’ve all heard that a passive buy and hold strategy may be more fruitful than a more active market timing approach. The truth is there’s no way to definitively prove which approach is more successful or dangerous. It often depends on the investor and the circumstances. But we can look at how the broader stock market has performed over time and we can ask, “What might have happened if I had bought and held stocks in the broader market?”
If we define a bear market as a decline of at least 20%, then the U.S. stock market as measured by the S&P 500 experienced 13 bear markets between 1926 and 2017 (according to Global Financial Data, FactSet, as of 11/8/2017). During this period, bear markets averaged a loss of 40%, while bull markets rose an average of 164%. In short, if you continually held S&P 500 stocks at any point from 1926 to 2017, you could be ahead despite any of the downturns occurring in that time. Of course, there is no guarantee of such events taking place in the future.
When it comes to lower-risk investment practices, these three principles are just the tip of the iceberg. But hopefully, they demonstrate that while “safe investments” can be a futile quest, while “lower-risk investment practices” can be a sensible pursuit. The more educated and well-informed investors are regarding risk-adjusted return, diversification, and long-term investment horizon, the better their risk management might be.
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