Risk

Return on investment and risk

rsz_risk and rewardWhen corporations make investments, they always consider two key metrics; return on investment (ROI) and risk. You need to do the same. And looking at these two metrics shows that your number one wealth building vehicle should be the stock market.

ROI measures the profit an investment is expected to generate and is typically expressed as a percentage of the original investment. For example, if you invest $1,000 and this investment earns you $100 in profit, your ROI is 10%.

With regards to the expected returns offered by the stock market, the long-term average return of the stock market (S&P 500) has been approximately 8% a year for the 10 year period 2005 – 2015, and closer to 11.4% a year for the 30 year period 1985 – 2015 (CAGR of the S&P 500 assuming dividends reinvested).

Risk, on the other hand, considers the possibility that an investment’s return will be different from what is expected, including the possibility that the investment may lose money. Risk is typically quantified using statistical terms such as standard deviation or variation. However, risk can also be stated in easier to understand terms that simply state what the chances of gaining or losing a certain amount of money are. For example, it could be stated that a certain investment has a 5% chance of losing more than 10% of its value and a 20% chance of earning more than 10% of its value.

Over the 30 year period between Jan 1985 – Jan 2015, the stock market (S&P 500) has generated positive annual returns 25 times and generated negative annual returns 5 times. It has gained more than 10% of its value 19 times and has lost more than 10% of its value only 3 times. It has gained more than 20% of its value 10 times and has lost more than 20% of its value only 2 times. Again, this assumes reinvestment of dividends and does not take into account any costs to purchase or hold these investments.

Looking at the returns discussed above, it can be seen that the stock market does go down some years, but over the long-term it goes up far more often than it goes down. Moreover, the risk of losing money becomes greatly diminished if investors are diversified and invested for the long-term (over 10 years).

 

Diversification

Diversification is essential in order to properly manage risk. Successful corporations know that diversification across product lines, industries, and countries, is key to managing risk and generating stable returns. You need to adopt this strategy too.

Johnson and Johnson has thousands of products spanning multiple industries that are sold in many different countries. This diversification has played a large role in the company’s ability to deliver stable, increasing dividends to its shareholders for over 50 years. Other successful corporations such as Colgate-Palmolive, Proctor and Gamble, and 3M, are no different. They all have large diversified businesses that have rewarded shareholders with steady increasing dividends for decades.

Diversification is all about not putting all your eggs in one basket. In order to reduce your risk, you need to buy a variety of good companies in a variety of industries. Not only that, you also need to hold investments in a variety of different asset classes too.

Asset classes such as stocks, bonds, and real estate, should all be included in your financial freedom fund. By owning all these different asset classes, you will ensure that if one asset class does poorly, your whole portfolio won’t do poorly. Diversification isn’t hard. It can easily be accomplished through simple purchases of ETFs or mutual funds, as well as through individual stock purchases.

I discuss more about how to ensure you are properly diversified, managing risk, and getting the best return for the least amount of risk in my book Think Like a CEO and Get Rich.

 

Invest for the long-term

rsz-long-termGet-rich quick schemes don’t generate financial freedom. Solid long-term investments do.

If you have bought the shares of a variety of large corporations that have a history of increasing earnings and increasing dividends, or if you have simply opted to buy some index funds, with the goal of mirroring the returns of a stock market index, then the next thing you need to concentrate on doing is not sabotaging your returns. This means you need to buy and hold.

The best way to sabotage your returns is to sell all your holdings when the stock market experiences a temporary downturn. Do not do this. If there is some fundamental change in one of the companies you are holding and you believe this company will not be able to continue to increase its earnings and its dividends, then, yes, consider selling it. If nothing has changed with the company’s business, however, and its share price is lower because of a general market downturn, then hold on to it.

In the short-term, stock markets can go up and they can go down, but in the long-term history has shown that they always go up. At the time of writing this, the last great stock market crash was the bear market of 2007-2009. During this bear market, the DJIA lost about 54% of its value from October, 2007 – March, 2009. Investors who sold at the bottom of this crash lost over half their money. Investors who held on to their holdings went on to make it all back and more.

If that is still not enough to persuade you that a buy and hold strategy is best, consider this. A $1,000 investment in the S&P 500 at the start of 1950 would be worth roughly $123,500 at the start of 2015. This is in spite of all the recessions and financial crises experienced along the way. Moreover, if you had invested $1,000 at the start of 1950 and then reinvested all the dividends you received, you would have been looking at an even bigger return, somewhere in the neighborhood of $1.1 million.

Strategies involving dividend reinvestment, dollar cost averaging, and portfolio rebalancing can further reduce risk and boost returns. I discuss all these strategies further in my book and plan to blog about them in future posts.

 

No risk, no reward

Unfortunately, you absolutely must take a little bit of risk if you want to achieve financial freedom and an early retirement. If corporations just sit on their money and don’t take any risk at all, then profit growth stalls and share prices tumble. Just like a successful corporation, you can’t afford to sit on your money either. You need to take a little risk and get your money working for you. If you don’t, not only will you fail to make any more money, you also might actually lose money.

 

Inflation

Inflation is a measure of how much the cost of living goes up. Moreover, the central banks of most developed countries target a growth in inflation of 2-3% per year. Therefore, even if inflation is at 1% per year, unless the interest in your savings account is greater than 1%, the money you save is actually worth less and less every year. Rather than becoming wealthier, you are becoming poorer.

If you had invested $10,000 in the S&P 500 at the start of 1995 and reinvested all the dividends, you would have ended up with roughly $65,600 at the start of 2015. If you had invested this same amount in a typical savings account at the start of 1995 and let it compound annually until the start of 2015, then you would have ended up with roughly $13,900 (based on historical average savings rates of Canadian Banks). That’s a difference of about $51,700 in favor of the stock market. This difference gets even worse when you factor in inflation.

When you factor in the effects of inflation, it would have cost $15,346 at the start of 2015 to buy what $10,000 would have bought in 1995. Therefore, since you invested $10,000 in 1995 and end up with $13,900 in your savings account, you cannot buy as much as you could have bought twenty years ago. By taking no risk at all and just leaving all your savings in the savings account, you have effectively lost money.

 

Going after higher returns

What if you agree with the idea that leaving your money in a savings account is a bad plan and you have bought a properly diversified portfolio of stocks, bonds, and real estate, but you still want to go after higher returns?

If this is the case, then the best way to seek out higher return for the least amount of risk might just be to adopt a strategy involving the use of leverage. Click on the link below to read more.

 

Leverage