Risk: To some people, it's a dirty word. After all, there are plenty of risks that may not seem worth taking at all, like using your credit card on a sketchy website, running with the bulls in Pamplona, climbing Mount Everest, or dining on poisonous blowfish. Risk is necessary in our lives, though, to some degree. The trick is finding the best degree of risk for yourself.
Risk and return
Risk relates closely to reward. Risk little, and you often get little. Risk a lot, and the payoff can be huge -- as can the loss. Think about Mount Everest and running with the bulls, for example: You risk your life in hopes of gaining incredible memories and lifelong bragging rights.
Risk and return are especially linked when it comes to financial matters. A low-risk, low-return type of investment would be a bank savings account, which would likely offer about 0.50% in interest. Bonds backed by the sturdy U.S. government are another low-risk, low-return option, with rates for bonds with maturities up to three years recently below 1%. Certificates of deposit and money market funds are not much better. You may feel comfortable knowing that you won't lose money with such investments, but you won't make much money, either.
In some ways, low risk is quite risky. If you need to grow a nest egg for retirement, for instance, money invested in safe, low-return vehicles will not likely grow into the amount you need to see you through retirement. If you start with $100,000 and it grows by 1.5% annually over 25 years, you'll end up with $145,000. And worse still, if inflation is around its historic average of roughly 3%, then you're actually losing purchasing power over time. Such a plan can doom your retirement.
The right risks
At the other end of the risk-return spectrum are high-risk, high-reward alternatives. An extreme example is a lottery ticket. It costs just $2 to buy a Powerball lottery ticket, and the jackpot can top $100 million dollars. That's an exponential payoff for such a small "investment." But there's a catch: It's risky. The odds of winning the grand prize are worse than 1 in 175 million. So while too-safe investments are often ill-advised, so are too-risky ones.
As with many things, though, moderation is best. We all need to find a comfortable middle ground along the risk-return continuum, where we're taking on a degree of risk we can live with in order to shoot for a reasonable return that serves our needs. For many of us with long time frames, the stock market is our best bet, and represents a risk-reward proposition that's smart to take on.
The overall stock market, over many decades, has averaged about 10% in annual returns. It does carry the risk of a major market meltdown at any given time, but so long as your time horizon is long, you should be able to ride out the downturns and the recoveries on the way to new highs. Given respectable returns of 10% per year, that $100,000 in our earlier example would grow to more than a million dollars over 25 years. Presto -- that's a retirement nest egg! And if you don't have $100,000 in the bank, know that you can reach a million dollars if you sock away $10,000 annually for 25 years and average annual gains of 10%.
Risks within the stock world
If you park your hard-earned dollars in the stock market aiming to build enough wealth to live off of in retirement, there are some more risks to be aware of:
- You need to diversify across many stocks and industries, which you can do by selecting a broad array of stocks or by choosing a low-cost, broad-market index fund that instantly exposes you to hundreds of diverse stocks. The Vanguard 500 Index Fund and the SPDR S&P 500 ETF are good examples.
- You should ideally diversify geographically, too, by investing in some international holdings or at least some of the many American companies that generate much of their income abroad. Apple, for example, generated a bit more than 50% of its 2013 revenue from Europe, Japan, China, and the rest of Asia. Meanwhile, Citigroup generated 56% of its 2013 revenue outside North America, while foreign sales accounted for 59% of Merck's total.
- If you choose to select individual stocks on your own, know that they vary widely in their risk profiles. Young, dynamic companies in growing or fast-changing industries are more risky than established behemoths in slow-changing industries. Shares of Coca-Cola, for example, can help you sleep better at night than shares of Groupon.
- Lower-risk, predictable companies also tend to pay dividends, which generate revenue in good and bad markets alike, so long as the companies are healthy. Coca-Cola recently yielded 2.7%, while Merck yielded 3%; both top most interest rates from banks, CDs, and Treasuries these days. Even steeper yields can be found, such as AT&T's 5.4% and Mattel's 5%. Those are likely to top even inflation all by themselves, leaving stock-price appreciation as icing on the cake.
- Once you have a long-term portfolio set to help you save for retirement, don't sabotage it by trading frequently or using services that charge steep fees -- these include certain brokerages, mutual funds, and advisors. Many wealthy people got that way by buying stocks and holding them for the long term.
For most of us, it's critical to build assets for our retirement years. Be sure you're taking on enough risk when you save for retirement so that you can build your wealth as quickly as you need to in order to retire in comfort and financial security.