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This is a continuation of the risk theme we explored in the posts titled “Winning Personal Finance Coin Flip Risk Assessment” and “The Stock Market Will Always Go Up Over Time.” In the first post, I presented a hypothetical coin flip as an introspective view of your own feelings about risk. In the second, we looked at some of the risks involved in investing in stocks.
Now we are going to try and tie the two together.
What does risk assessment have to do with stock investing?
The point of the coin flip test was to see if you would be willing to take on risk in order to make a bet with positive expected value. In the hypothetical bet, you could expect to win $500 on average while risking $1,000 with an immediate payoff. While the stock market is not likely to return 50% in a minute’s time, we’ve shown that it has a positive expected return. If you invest in the stock market index in the long run (10+ years), there is a very low chance of loss.
Due to fear of losing, many people would pass on the hypothetical coin flip and do pass on investing in the stock market. Unfortunately…
There Are Risks to Not Investing
Opportunity cost is the cost of missing out on one opportunity in order to do something else. Let’s say you have $100K and invest it in the US Stock Market. Then, it returns exactly 8% each year for the next 20 years. At the end of the 20 years you would have just over $466K. If you had left that money in a savings account earning 1% during this same time, you would have just over $122K. That is a difference of $344K! I can think of many ways I’d like to spend that extra $344K and am willing to give up some peace of mind in order to get there. Even though there is risk of loss with stocks, for any long term period of potential investing, I fear the risk of missed gains more. This is what drives me to keep most of my savings in the market.
Inflation & Purchasing Power
As time goes by, inflation makes the stuff you buy more expensive. Prices almost always go up. So if you earn 1% in your savings account and inflation is 2%, your money would buy less, even though the amount you have has increased. This is yet another reason to try and earn higher returns.
How to Lose One Million Dollars
The Wealthy Accountant posted an article called How to Lose a Million Dollars in a Day. It’s a fun, initially sarcastic read that I highly encourage. I think the takeaway from it ties in well to the points I’ve made in this series. In order to increase your net worth, you need to both save and invest. In the long run, investing in the stock market via a low cost index fund will yield strong returns. Once you have significant assets, you also may be able to say “I lost a million dollars today, and frankly, I don’t give a damn.”
Why Taking Risk is Important
This blog is designed to help readers make efficient financial decisions to accomplish their financial goals. If you naturally fall into the trap of fearing risk, think about your investment philosophy and try to find the right balance – even if it makes you uncomfortable. It’s possible that you already have the ideal portfolio for your financial situation. On the other hand, if your natural risk profile does not match your financial situation or if you have not evaluated your portfolio recently, there’s a good chance some changes are necessary.
Your investment strategy should be based on your personal financial situation. The answer is not for everybody to invest 100% of their net worth in stocks. A 100% stock allocation may be right for a 22 year old starting from scratch. While a 65 year old that’s about to retire and live off their savings may require a different strategy with a higher allocation to “safer investments.” In the meantime, a different 65 year old whose needs are fully funded by social security and a pension may decide that a 100% stock allocation is right for them, since they want to maximize their returns and have more for their heirs. Personal finance is personal. The keys are:
- Set up an asset allocation that is based on your individual goals and personal financial situation
- Stick with your strategy through the ups and downs
- Enjoy the returns when you need them.
Remember: while there are risks associated with investing, there are risks of not investing also.