Matching Risk and Reward
Short-term investment options

by George Runkle (TMFRunkle)

ATLANTA, GA (July 6, 1999) -- This afternoon I had an interesting discussion with my older son, George, about buying stocks. He's been working at Domino's Pizza for the past few months, and is doing very well in saving his money. It's going into a money market account with a discount broker. It pays more interest than the bank, and he can write checks on it as well. Now, this is fine for saving, but what about investing?

In my discussions with my son, I realized a teenager has a different perspective on investing than I do. I'm trying to prepare for my retirement, which is at least 20 years away. With that long-term horizon, I can take a number of risks, which will even out in the long run. Young George has two horizons -- he wants to buy a car next year, and he is going to college in two years. So, what should he do? Keep his money in money market funds, or invest it?

Our discussions covered several different ideas. George wanted to invest everything in Microsoft (Nasdaq: MSFT), but I pointed out that it is fairly volatile, and did he want to risk losing money in the next two years? He doesn't want to lose any money. Also, he would need to save up more cash so commissions wouldn't kill him. Well, that leaves out a number of "high tech" investments.

We do have some of his funds in S&P Depository Receipts (AMEX: SPY). Since they have to be bought through a broker, like Microsoft, you really need to make at least a $500 investment to keep commissions from eating your money. Also, it wouldn't be a good idea to put all the assets he has in the S&P 500 with his short time horizon. What if the market tanks next year or the year after that? He will be forced to cash in at a bad time, and probably lose a lot of money. That eliminated them.

So, we realized that George needed to be able to invest small amounts of money in a company so he could keep some cash available in his savings. We looked at Lucent Technologies (NYSE: LU). Lucent is a fine company, but he needed $1,000 to directly invest in the plan, or had to agree to a $100 a month automatic withdrawal from his checking account. I'm not real thrilled about the prospect of my son having a $100 a month obligation while he is in high school, even if it is an investment. Also, his earnings won't be as high in the school year and he wants to have some cash left over. We also got back into the volatility issue -- putting even some funds in Lucent might not be a good idea for my son's risk tolerance.

Where did we end up? Some years ago I set up a Drip account in Texaco (NYSE: TX) for my son. It only required a $250 initial investment, and voluntary contributions can be as low as $50 a month. Using this account means George doesn't have to wait half the summer for a new account to be set up for him. The other advantage is oil companies are not very volatile. Generally, their high yield keeps the prices from dropping too far.

One common measure of volatility is beta, which is how much a stock moves in relationship to the market. A beta of 1.0 means the stock moves up or down with the same percentage as the market. Higher than 1.0 means it moves up or down more than the market, lower, less than the market. Texaco has a beta of 0.44, which means it doesn't move much at all relative to the market.

Personally, I believe in using a stock's beta as a way to match a portfolio with one's risk tolerance. The higher your tolerance, the higher your beta can be. For myself, I can have a fairly high beta in my portfolio, since it really won't hurt me if my portfolio drops in half over the next two years (I wouldn't be happy though).

With the low beta and reduced risk goes a lower reward of course. In the past year, with reinvested dividends, your return on Texaco would be about 6% by my quick and dirty calculations. That's not so good when you consider the S&P 500 returned about 20% in the same period. Right now for a two-year Treasury note you can get a 5.75% return. However, my son doesn't make enough taking pizza orders to buy a T-Note, and he needs a bit more liquidity than they provide anyway. After all things are considered, it still makes sense for him to invest some of his funds in his Texaco Drip account.

In summary, we need to match our investments with our risk tolerance, need for liquidity, and amount we have available to invest. Before investing in a Drip, it's necessary to analyze our personal needs first and then try to find the best investment to match them. It may be necessary to trade away higher returns for lower risk depending on our situation.

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