If nothing else, the recent financial meltdown provided an important learning experience and reinforced time-tested concepts about risk in investing. None of these lessons will comfort investors. However, we can still evaluate investment risks, at least on a relative scale.
Conservative investors fear loss of principal above all. They flock to lower-risk vehicles, such as Treasury bonds, CDs, and money market funds, which are comparatively well known and easy to understand. They’re willing to accept a lower ceiling on their potential earnings in exchange for a lower risk of losing principal. However, this reasoning ignores or underrates a different but no less serious risk: that inflation will outstrip the earning power of the investor’s savings, causing the principal to lose value even when achieving its maximum rate of return. In the worst case, conservative investors can outlive their investments.
Aggressive investors have no problem with risky investments if the investments carry a high profit potential. The more rational risk-takers recognize a corresponding loss potential and accordingly risk no more principal than they can afford to lose. Less rational people may continue to risk everything until little or nothing remains.
The wisest investors take a balanced approach. Since most have neither the time nor the resources to analyze individual investments in depth, they generally refer to advice and analysis provided by outside sources. They also diversify their holdings so that if one investment fails, their portfolios are not irreparably damaged.
The mix of assets in your own portfolio should reflect your risk tolerance, but it also should be tempered by an awareness that both extreme caution and excessive risk-taking can be pathways to ruin. In general, no one stock or other single investment (excluding mutual funds, which are bundles of investments) should comprise a major part of your portfolio. Varying the types of assets in your portfolio (foreign vs. domestic stocks, bonds, mutual funds, Treasury bills) can provide an additional margin of safety.
You can’t escape risk in the world of investments, but you should try to choose the investments that fit both your risk comfort level and your personal financial situation.
David Bradsher, CPA Â is aÂ Washington DC / NorthernÂ VirginiaÂ area CPA who works with small business owners and non profit leaders on a monthly basis to provide them with guidance and advice on how to grow their organizations, minimize their tax liabilities andÂ increase their bottom line.