What Kind Of Investing Is Best?

 

Does it pay to rish everything?

Does risk truly bring success?

 

Rocketing To Success

 

Judging from the news stories, risk takers are the ones who rocket to success in life.  Is that true?  We’ve all heard warnings such as, “Investing is wise, but speculating is a fool’s game,” or “Don’t gamble away your money.”  What types of investments are best for you?  Let’s find the answers.

 

The Four Approaches To Investing

 

Perhaps you wonder whether to buy stocks, invest in real estate, or sell everything and move into gold. It turns out your overall approach to investing is more important than the things you buy and sell. Whether you are aware of it or not, you already have a built in tolerance or aversion to risk.  This is your “risk profile”—something that affects every choice you make. It therefore pays to understand the risks and benefits involved with various types of investing.  You want to be certain you select investments that match your profile.  Otherwise, they can work against you.

 

There are four distinct strategies for investing.  Each strategy differs according to the risks and potential rewards.  Depending on your risk profile, your goals, your age, and your patience to be rewarded, one of these strategies will appeal more than the others. This does not imply one strategy is better than another.  In fact, many successful investors employ two or more of these strategies at the same time.

 

1. Safe Investing

 

A safe investing strategy is appropriate if your tolerance for risk is small.  You prefer caution and avoid risk. Your goal is to keep your money safe, even if it means sacrificing high returns. You do a thorough analysis of a potential investment before risking your money.  An FDIC guaranteed savings account is an example of safe investing.

 

2. Aggressive Investing

 

An aggressive investing strategy is return-driven. You have ambitious goals, and you are not satisfied with the small, slow returns possible from safe investing. Your investments include stocks and bonds that offer higher returns, but also carry a risk of losing part of your money. You seek to minimize the risks of investing, but you are not willing to sacrifice the potential for higher returns.

 

3. Speculating

 

A speculative investment strategy is one that takes on large, calculated risks. You seek quick, high returns.  You are less concerned about losing money on any one deal than the aggressive investor is. In fact, your tolerance for risk makes you willing to accept an occasional loss of your whole investment, as long as the investment promises high enough returns on average.

 

4. Gambling

 

A gambler’s strategy of investment seeks big wins with little caution. Your tolerance for risk is even higher than speculators.  You are willing to lose money on average as long as there is at least a small possibility for a big payoff.   Note:  Gambling is not a meaningful investment strategy, because the odds work against you over time.  Your average returns are always negative, by the casino’s design. True, you can get “lucky” on occasion, but it is rare when luck alone makes up for losses.

 

Do Your Research

 

Lots of investement choices.

Where do you begin to invest?

No matter which investment strategy you employ, it is essential to research and analyze an investment prior to putting down your money.  Many investors fail to do their homework. Perhaps they heard about someone who “won big” in a particular investment, or maybe they were convinced to invest by a strong sales pitch.  In a sense, any well-intended investment strategy becomes gambling when we fail to understand the risks involved.

 

Combining Investment Strategies

 

Many investors use two or more investment strategies at the same time. For example, one person might employ a safe investing strategy with 50% of his portfolio, an aggressive strategy with 45%, and a speculative investing strategy with the remaining 5%. As he nears retirement, he might switch to having two portfolios, 60% for safe investing and 40% for aggressive.  The reason many investors move to bonds and other safer investments as they grow older is due to the simple fact that they have a shorter time span to recoup any losses.  Your investment mix should ultimately be determined by your tolerance for risk.  TIP: A good investment adviser will help you determine your risk tolerance before recommending an investment.  If they don’t, take your business elsewhere.

 

 

The Risk / Reward Connection

 

Understanding the strong link between risk and reward is critical for investors. If you seek high rewards, you need to accept higher risks. That’s how the world works. Lower risk investing generally leads to slower, but more certain success.

 

Is slow success a bad thing? Not always. In reality, the tortoise often wins the race. When you accept high risks, sometimes you lose, and it can take a very long time to recover from a major loss. [For more information see: A Key Secret to Winning as an Investor]

 

For example, speculating in real estate may return a quick payoff, but it also carries significant risk. And those risks multiply whenever you need to borrow money to make the investment.  If a speculative deal goes wrong, your losses can be huge—you lose the money you started with plus the money you borrowed.  In a worst case scenario, one bad speculative play may wipe you out.

 

On the other hand, investing in a savings account at a bank risks little or nothing, but your return is very limited. It is important to determine the right level of risk and reward—one that satisfies your goals for earning, but also lets you sleep at night.  If you want an objective opinion of your risk tolerance, try taking a short quiz on the subject.

 

The Safe Investing Strategy

 

In this strategy, your original investment (or principal) must be protected at all costs, even if it means accepting a small return. Ideally, both your principal and return would be guaranteed by the government or by a financially secure company. Every investment strategy actually includes a range of risk-taking.  To improve return, some safe investors may invest in things that risk a small portion of their principal—a few percentage points at most.  On the other hand, the most conservative of safe investors accept zero risk to their principal.

 

Save Your Pennies

Even small change adds up.

The most common forms of safe investing rely on collecting a long series of small, safe returns—for example, the interest you receive on a savings account.  This is made easier by “compounding”.  By reinvesting returns as they are received, an investment builds on itself.  At first, the results of compounding appear to be gradual, but over time they snowball.  For example, on your 20th birthday suppose you invest $1,000 at 2% interest, compounded annually. On the day you turn 21, the bank credits your account by $20.  That’s the interest you’ve earned over the past year, so now you have $1,020. Over the next year, you earn interest on $1,020 instead of $1,000. In other words, your wealth grows slightly faster each year because the earnings (or interest) are generated off on an ever-increasing sum. By the time you retire at age 65, your original investment of $1,000 will be worth $2,438. Without the bonus you received from compounding, you would have ended up with only $1,900—a $538 difference.

 

To retire in style, a safe investor starts young and makes steady, consistent investments.  For example, a 20 year old investing $80 a month, at 2% interest until age 65 would accumulate a retirement nest egg of $70,169.

 

Safe investments can include CD’s, treasury bills, insured annuities, and some forms of bonds or bond strategies. Treasury bills are considered one of the safest investments of all, but like savings accounts they offer very low returns at times. Banks that offer FDIC insured CD’s often compete on rates to attract new customers. Annuities from large insurance companies can be safe, but they come at a cost of lower returns due to management fees. Sometimes the fees are excessive, so caution is needed.

 

Bonds rise and fall in value all the time, as interest rates change. When interest rates go down, bond values go up.  When rates go up, values go down.  From a historical standpoint, some guaranteed government bonds such as “Ginnie Maes” offer solid rates of return and relatively stable values—a decline of 10% would be rare. With the exception of inflation, if you plan to hold a guaranteed bond over the course of its life there is no real risk to your principal. However, if forced to sell a bond before it matures, you risk losing a portion of your principal.  This makes bonds more risky than savings accounts or CD’s. Technically, you are holding an instrument that swings in value all the time.

 

All bonds are rated for risk.  The safest of the lot are those backed by the full faith and credit of the U.S. government.  These include U.S. Treasury Bonds and TIP Bonds.  Bonds issued by states and local governments (e.g. municipal bonds) are generally considered safe, unless the local government or state issuing them suffers from an ongoing budgetary crisis. Companies with stellar financial track records often issue bonds of high quality.  Though top rated company bonds are not guaranteed, the companies issuing them strive to maintain their credit worthiness since a reduction in their bond rating can cost millions or even billions of dollars.

 

Yields on bonds reflect the risk of losing your principal or interest.  Most “safer” bonds offer low yields.  Less secure company bonds or foreign government bonds offering high yields carry higher risks.  When you buy a high yielding bond, you assume a much higher risk of losing either your principal or interest.  This makes them unsuitable for the most conservative of investors, though some less cautious investors include them as a small part of their bond portfolios. A word of caution: Because interest rates have been at historic lows, some analysts warn of a potential “bond bubble”. If rates begin to rise sharply, bond prices could tumble. This makes it even more important for the safe investor to buy and hold guaranteed bonds until the date of maturity.

 

Inflation and taxes are two significant hazards for the safe investor, because they can eat up returns. Strategies for offsetting these hazards include buying U.S. Treasury Inflation Protected Securities (TIPS), buying tax-free municipal bonds, or investing through a tax-deferred account such as a Roth IRA.

 

The Aggressive Investing Strategy

 

The aggressive strategy stresses that investors exercise due caution as they seek higher returns, while choosing investments that can provide them. The choices would include high quality stocks, bonds, mutual funds, exchange traded funds, precious metals, or even high quality collectibles such as antiques or fine art.

 

Aggressive investments like these entail additional risk-taking. Though each is considered common in the investment world, they all experience different levels of volatility—that is, they experience frequent fluctuations in price that can be large. For this reason, aggressive investors must be willing to accept the possibility of substantial losses to their investments—as much as 25% to 50% of principal. These can be mitigated somewhat by selecting investments with lower volatility, but that also limits returns.

 

It is important when talking about losses (or gains) to know when you’re talking of realized losses or “paper” losses.  Investors are most interested in realized losses.  These are the losses they report to the IRS when it comes to paying taxes.  Once again, whether investors sell at a loss depends on risk tolerance.  History has proven time and again that what goes down eventually comes back up.  Aggressive investors willing to ride out market fluctuation may be able to offset big losses easier than those that jump ship the minute a stock takes a hit.  Investors who gain a keen sense of their tolerance for risk, find it easier to select investments.  All investments carry risk, but some risks are more predictable than others.

 

Why make an investment at all if it could suffer a 25% loss? Think back to the issue of risk versus reward: The higher the risk, the higher the potential for reward.  If we aim for higher risk investments, it’s because we believe we can choose enough winners over the long haul to make it worth our while.  To up our odds, we select investments that are more likely to rise and less likely to fall.  We also select for quality, and we diversify our portfolio to lower overall risk.

 

The Speculative Investing Strategy

 

The speculative strategy places a high priority on quick, large gains. In the real world, it is difficult to generate consistent success with this strategy. One approach is to choose investments that have a strong chance for an overall gain when repeated many times, even if there is a chance for a big loss on occasion. In other words, on average, all of your gains outweigh your losses, including some big losses. This can be achieved by looking for investments where your special knowledge or experience comes into play, so that you can make realistic estimates of a potential outcome.

 

Is speculating worth it?

For example, a speculator might borrow money to invest in real estate. This is a high risk venture.  By going into debt, he can buy a larger property. If the investment works as expected he has multiplied the power of his dollar.  It should go without saying that if the venture fails, he may be in real trouble—he loses his original principal and may still be on hook for the debt. To better his odds, he relies on his skills and experience with previous real estate ventures.  An important note:  Experience or knowledge alone doesn’t guarantee a particular deal will generate a profit, but in the long run it ups our odds that the wins outweigh the losses.

 

Other speculative investments include penny stocks, commodity futures, naked option plays, buying stocks on margin, or investing in exchange traded funds or mutual funds that try to double or triple the rate of return on market indices   If you invest knowing there is a good chance for total loss of principal, be aware your investment is speculative.

 

A stock market speculator might choose to invest in low priced stocks if he notices that they occasionally experience large percentage gains. He may develop a system to pick stocks that predict a jump in price, perhaps one time in three. If one stock pick results in a big gain it may easily outweigh several previous losses. In other words, if his average gain is high enough, he is better able to afford losses on those stocks that fail to pan out.

 

In reality, speculators face many challenges. For one thing, probability is fickle. It is quite common to flip a coin and receive 10 or 12 losses in a row, even though the odds for each toss are 50/50. Speculating correctly is not gambling, because it means choosing investments that offer a positive outcome on average. However, speculation is not a game for the small of wallet or for the faint of heart.

 

The Gambling Investment Strategy

 

Better start praying.

The gambling strategy is not really a strategy; it is more a hope. As a gambler, you recognize and accept the fact that on average the casino wins some of your money on every play, even when you include your big wins. However, you bet anyway, on the slim chance you could develop a hot streak or luck out with a freak win. It does happen.

 

You can win a lottery jackpot the first or second time you ever bet. When you get this lucky you feel like you’re on top of the world.  You blow away the odds. This is how gamblers get started.  Just remember, longer term gambling gives your early advantage with the odds back to the house.  The odds don’t really change, but your luck does.

 

There are spectacularly lucky people who win big despite the odds against it. There are even people who win million-to-one lotteries twice. The dream of being one of those people is the motivation for people who gamble.

 

A speculator wanting to beat the casino’s odds would buy the casino’s stock, instead of going inside to gamble. He does this because he knows casinos always win in the long run. To better understand the differences between speculation and gambling, see the article, “Are Speculators Just Gamblers?”

 

What Kind Of Investing Is Best?

 

The best strategy for your success as an investor is getting to know your unique “money personality”.  Understanding your risk profile, your goals, and your patience for reward are key factors for determining a specific plan of action. Also critical are a host of other factors including age, current net worth, income, education, health and family obligations.

 

The less you know about investing, the better it is to avoid all speculative investments.  This is true even for experienced investors. Losing everything is something most of us want to avoid at all costs, yet it is a daily possibility for the speculator.

 

Remember the relationship between risk and reward: With higher reward comes higher risk, and bigger losses.  Probability is fickle.  It can bring the biggest surprises when you least expect them. Major losses are difficult to recover from. After you gain confidence and experience in investing and can set aside a small portion of your portfolio for speculative plays, you may discover the potential rewards worth the added risks.

 

To strike a balance between being too conservative and too aggressive, consider balancing your portfolio to diversify risk.  Most important, understand your aversion or tolerance for risk.  When you get a good handle on your unique money personality, choosing among the various investment types becomes easy.

 

As always, if you are confused or unsure about the risks of any investment, be sure to seek professional advice.

 

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