8 Risk

Finance professionals spend each day looking for new ways of analyzing stock data to better understand past performance and attempt to predict future performance, and the above indicators are by no means an exhaustive list of features that may describe a stock; if the safest way to protect investments against unexpected downturns of individual companies is to diversify, or invest in many companies or asset classes at once, then regularly sifting through pertinent data for each company quickly becomes a folly endeavor.

Investing is a “zero-sum game,” meaning that, compared against the average performance of all companies, any better-than-average performance by one company is unequivocally accompanied by below-average performance by some other company.  Likewise, for each investor that outperforms the average of all companies, some other investor necessarily underperforms.  Rather than hoping a particular fund manager will fall on the positive side of this equation, index funds allow the individual investor to purchase many stocks at once as part of a particular basket that seeks to follow a major index.  The Dow Jones Industrial Average (also known as the Dow) is one such index—the Dow is a collection of “blue chip” (after the largest poker chip—a telling sign of the relationship between stock picking and gambling) companies; the index is periodically re-evaluated, and if a company is no longer representative of this most “elite” tier of companies, it is no longer included.  But, other indexes like the Standard and Poor’s 500 seek to capture a more diverse representation of the market on the whole.

Funds that merely track the current companies and their respective weighting on the major indexes are passively managed, since investors are not relying on the fund manager to pick superior stocks in the hunt for capital appreciation.  Funds for which the manager actively tries to identify investments that will outperform the market on the whole are actively managed.  Some funds require a certain minimum investment to join—such information, along with more detailed specifics about fund allocation and investment strategy, can be found in the prospectus, a report filed by the firm responsible for maintaining the fund.

Bonds, or debt obligations in which an investor loans money to an entity like a company or government body, can be very safe or very risky investments, depending on the issuer.  Moody’s and S&P both offer rating systems for bonds based on the creditworthiness of the issuing entity; bonds offered by the federal government are considered safer (more likely to be paid back to the investor) than bonds issued by smaller, less trustworthy entities.  Bonds or offered by an issuer, usually a company or government entity, and have a face value, which is the initial principal investment made by an investor as a loan to the issuer.  At the maturity date, the principal is returned to the investor along with interest, which is sometimes called the coupon, from when bonds were issued as paper documents—detachable coupons could be mailed to the issuer in order to redeem interest payments.

Most commonly, bonds will be bought or speculated upon in large-scale quantities as part of balanced mutual funds; since bonds have interest rates and resultingly predictable return-on-investment (ROI), they can be stable over much longer periods than stocks, and bonds offer more modest gains.  Bond funds can, like mutual funds, give investors access to the relative safety and stability of bond investments without the headache of researching and acquiring individual bonds.

Because of their stability and somewhat independent performance compared against stocks, bonds make up a useful component of mid-range investments.  Balanced funds that mix stock and bond investments can make for easy, consolidated options for investors looking to keep up with the rising cost of goods while saving for upcoming expenses.

When considering long-term asset allocation, a more stock-heavy (as applied through stock-heavy mutual funds) approach is more typical, as stocks historically have always performed with a generally positive return over investment periods of 25 years or greater—under such long time-horizons, stocks have historically been safer.  Commonly, retirement planning is a long-term investment, and the power of compound interest, when captured early, can be a strikingly powerful tool.  At an 8% annually compounded rate of return, a $1,000 investment at a young age, 45 years before retirement, would grow to almost $32,000.  Note that at the time of retirement, $31,000 of the contents of the investment would be interest of interest, in addition to the original $1,000 investment.

But, a word of caution: stock market investments are theoretical, “unrealized” gains or losses until they are actually sold—a market in which other investors are willing to pay a premium for your shares in a certain mutual fund can always abruptly shift, resulting in evaporated profits.  As the time until retirement diminishes with age, investments should generally be shifted to safer, more stable financial instruments.  Any asset that is invested in a financial instrument that is not FDIC-insured is vulnerable to downward economic pressure, meaning assets can depreciate (which happens often under short time windows) or lose value entirely under exceptionally rare circumstances.

This also means that an investment does not lose value simply because other investors are not currently willing to pay what you deserve for your shares of a fund—the golden rule of investing in financial markets is “buy low; sell high.” Should the price of assets globally fall, history tells us that they will eventually surpass the previous peak.  Savvy investors know to trust the cyclical nature of economics and avoid selling off an asset because of a temporary decrease in value.  However, if the investor purchased shares in one particular company or one small subset of the economy, the investment might not recover.  The investor’s ability to withstand periods of economic decline is known as their risk tolerance.

Investments may be purchased through a brokerage firm.  Some brokerage firms specialize in curating their own mutual funds and can offer free transactions when investing in their own funds; other firms focus on offering low-cost trades for investors who hope to make individual stock trades often.  Before deciding on a firm, investors should research the prospectuses for potential investments, paying close attention to the cost basis, or how much overhead the fund incurs (even cheap index funds—which seek to follow broad market indexes—incur fees when companies need to be bought or sold to maintain weighting from the index; and those transaction fees are passed on to investors) and the history of funds.  If a company is new to the market, they might offer lower cost basis, but newer financial instruments may lack a track record to show investors that the investment has historically been safe.  Actively managed funds tend to levy a higher cost basis, but some firms prioritize keeping the cost low over time.

Remember that the increase in an asset’s value is not realized until it is liquidated (sold).  Over time, the fee structure of an investment asset can diminish yearly returns, and any increase in value of a financial instrument over time can be subject to capital gains tax—in some cases the tax is imposed as the asset grows, and in other cases the tax only kicks in when the asset is turned back into cash (sold).  In either case, the real gains on an 8% positive return (increase in value) are whatever is left over after paying brokerage fees, fund management fees, and taxes.  Even a 1% cost basis leaves the investor with a 7% return, which represents a hefty potential for increase in asset value over its life, especially compared against erosion of spending power assets experience in savings or checking accounts.