Investing: Risk vs Reward

I was sitting in the kitchen at work one day when the discussion turned to the 401K plan. Someone said she wanted her money in the lowest risk fund but she wasn't sure which one that was. I told her there was no such thing, that the question was which risks was she willing to bear. That was one of many discussions I've had with people over the years that have convinced me that there are a lot of people who consider the stock market to be just another version of the lottery--something that may make you money, or may not and over which you have very little control. I'm going to talk today about risk and reward in investing.

Risk is about possibilities. Let's say you are paying all your bills every month, but you aren't saving anything for the future. The risk, the possibility is that you won't have enough to live on in the future. The reward for living this way is having more money to spend now. If you know you carry the gene for Huntington's disease, which will kill you in your 40's and you are single with no kids, then the reward of living better now is worth the risk that you will outlive your money. If you are in your 50's now, used to a high standard of living and have genes that indicate you are likely to live a long time, that risk/reward analysis is different. Let's look at the risk/reward analysis on some investments:

Bank Accounts

Bank accounts are insured by the Federal government; if that insurance fails we all have lots of other problems, so when you put your money in the bank, it is safe, right? Kind of. If you put money in the bank it earns a very low rate of interest, and you have to pay taxes on that interest. By the time you are done you are not keeping up with inflation. While you have more dollars after years of saving, your purchasing power decreases. The risk you bear with bank accounts is inflation risk. However, your principal amount is safe, which means that bank accounts are good places for money you are going to need in the next few years. You may lose a little purchasing power, but you know how many dollars you will have.

Bonds

Bonds are pieces of paper (or computer entries) that say you lent money to someone. They entitle you to repayment of that debt, plus interest. There are two risks involved: repayment risk and interest rate risk. Repayment risk is what it sounds like--the risk that the issuing entity will not be able to repay the loan. Loans are graded by the creditworthiness of the issuing entity. US government bonds are considered the most secure; bonds of companies in turmoil, much less so. Here is where the concept of risk and reward comes in. If you had $1000 to invest, would you rather loan money to the US government or to a company that is in financial trouble? If the bonds have the same interest rate, the choice is easy and that company in financial trouble would never be able to borrow money. In order to induce you to take the risk and buy their bonds, that company in trouble has to offer more, they have to pay higher interest. In return for taking the risk, you hope for the higher reward, and if the bonds are properly priced, you should get it. Interest rate risk is the risk that interest rates will change substantially during the term of your bond. If you buy a bond today that pays 3% interest and then things change in the economy such that a similar bond could be bought that pays 6% interest, you are stuck with your 3% bond until it matures. While you don't actually lose any money when interest rates rise, you do lose the opportunity to invest that money at a higher rate. If you need to sell the bond and convert it to cash, you will lose money. Conversely if interest rates fall, you continue getting your high rate until the bond matures. If you need to sell it, you can command a higher price. Bonds are called fixed income investments because the amount you can gain from them is fixed (absent a big move in interest rates). Unfortunately, the downside to all except government bonds is that you can lose your entire investment. With high quality bonds, that's not likely but it is a possibility. The way to mitigate that risk is to diversify and not put all your money in one bond.

Bond Funds

Bond funds pool the money of many investors and buy many different bonds, thus mitigating the default risk. Because the fund is always getting in new money and buying new bonds, the interest rate risk is also somewhat reduced. However, bond funds go up and down in price daily, and the longer the term of the bonds in which the fund invests and the lower the quality of the bonds, the more the share price varies. The risk of losing all your money in a bond fund is minimal, but if you have to sell shares when the price is down, you could suffer a loss. On the other hand, bond funds pay interest regularly. Over the long term, bond funds on average pay less than stock funds, but their interest payments and the fact that their share prices are generally more stable than stock funds make them a good counterpoint to stock funds in a portfolio. In short, by putting money in bonds, you give up some of the upside, but some of the downside as well. Because they under perform stock funds, putting too much money in bond funds at too young an age exposes you to the risk of not maximizing your investment potential. That's why investment pros recommend investing heavily in stocks when you are young and in bonds when you are old.

Stocks

When you buy shares of stock you buy part of a company. If that company does well, you may be paid dividends, and/or the price of the stock will rise. If the company does badly, you could lose everything. On average, stocks out perform other investments and always have. However, that average is made up of stocks that have flown and those that have crashed, as well as a bunch in the middle.

Stock funds

Because stock funds invest in a large number of companies, the risk that one poorly performing stock will ruin you is reduced. Of course, it also reduces the chance that one high flyer will make you rich. Over time, a well-diversified stock portfolio has out performed any other asset. If you choose not to invest in the stock market in some way, you are choosing to make less money than you could.

Peer to Peer Lending

Most people's Prosper or Lending Club portfolios are like mutual funds--they have little pieces of a lot of investments, which reduces the downside when any one investment goes bad. That is why both Prosper and Lending Club recommend a minimum investment of $2,500. Any less than that and your returns are much more likely to be extremely high (if you get lucky and have less defaults than average) or extremely low (if you aren't lucky).

Kickfurther

Kickfurther has been an interesting study in risk vs reward. At first, 1.5-2% per month offerings were common. As the number of investors grew, it got to the point that you had to log on at 4:00 p.m. and not 4:01 to get in on offers. Slowly the rates came down. Then the defaults started to hit. As of this writing, about 80 Kickfurther offers have been paid back in full. About 11 have been cancelled for non-payment. Some of those have made some payments; some have not. Even if you figure an average of 50% of those bad offers being recovered, in order to break even, investors need a return of over 16% per year on good offers, on a platform-wide basis, or investors need to learn to avoid the bad offers ahead of time. Time will tell if that is possible. In any case, as the offered interest has been going down, the size of offers has been going up, and investors aren't filling them. Now we see rates creeping back up. I enjoy writing about Kickfurther but at this point I can't tell you that the reward is adequate for the risk; as a matter of fact, right now, I don't think it is and I'm not adding more money to my account. Unless the reward increases, I'm going to withdraw my money.

Lottery Tickets

Since I started the post with a picture of a lottery ticket, I thought I'd take a minute to address them. My office does a weekly lottery ticket pool. I don't play. Why? Because I don' get $2.00 worth of amusement out of watching the lottery pick on TV. Yes, someone will win eventually, and you can't win if you don't play, but any statistical analysis will tell you that the risk of losing is almost 100%. If you can afford to waste a couple of dollars and it amuses you, go ahead and play, but it is amusement, not investment.