Low Risk VS. High Risk: What’s Better?
Today, I want to talk to about low risk versus high risk investing. I want to tell you story about a conversation I had with a friend, where he was insistent on making 4% on his money in his 401(k) as the safest way to invest. I was trying to explain to him the risk of taking too little risk. I suggested he might be better off trying to earn more dividends on that money.
I’ll take you through the conversation we had. Hopefully, I can explain my point of view to you, the reader. Before I begin, it is a good idea to understand that all investing involves risk. I am not telling you to invest in any product, but just making you aware of something you’ve been told is good for years. Of course, I don’t want to lose money, nor do you. However, everything involves risk, including just waking up in the morning! Even low yield investments involve more risk than the investor realizes. I’ll explain that later.
To summarize our conversation, he wanted to make 4% instable products, such as bonds, notes, and government debt type instruments. I was interested in earning a higher yield, closer to 12% investing in products like REITs, closed-end funds, and maybe index funds.
In the accompanying video, each of us started off with $100,000. 4% Guy’s hundred thousand dollars at 4% per year yielded $148,024. 12% Guy starts with $100,000 and earns 12% a year for 10 years and yields $310,584. That would be an approximate 209% increase over the 4% guy, which in this instance is a no-brainer.
However, you know, the discussion was what is better a higher risk or lower risk? We changed the scenario and asked if 12% Guy’s investments took a hit. We thought maybe, as an example 12% Guy takes a haircut on his investments when the stock market goes down. Let’s look at that. We took the 12% Guy and in the example, he takes a 50% loss on his investments in one of the ten years. For simplicity sake, we used year number five. Keep in mind, different things would happen between years one and 10 depending on what year the loss occurred. Going back to the slide in the video before if you took the loss at year two, you end up with $60,000 so it would take you longer at 12% to get back your loss. If you took it at $277,000 in year nine. You’d be at what 130 something thousand dollars, you’re going to make that back in the next year so it does have the same bearing. For the demonstration in the vide, were going to just do it in the middle of the 10 years at year number five and a 50% loss.
Now it’s not very common to take a 50% hit in one year, but this is just to show you an example. In real life, the 50% hit could be distributed over two or three years, as happened in 2006-2008, the likelihood of this happening is possible, but it’s more apt to be 10-20% loss over a couple years.
The 4% guy still earns $148,024 in the end. However, in year five. For 12% guy, we cut the four year income in half and then started again down the years. The 12% Guy still earned $155,291 by the time it was all over, which is still 4.9% over the 4%. In this case, the risk is actually still lower by earning a higher yield. Now when you earn a higher yield, you want to do it safely. If you make bad investments, just trying to seek yield alone, you could easily get more than a 50% loss in your in your principal. Still be careful with what you invest in.
I’m currently invested in REITs and closed-end funds, and some other high yield instruments. I also have things that hedge off risk to the downside sitting in my 401(k) and I’ll explain that to you in future videos.
In closing, 12% guy won either way. I explained that a 50% haircut earlier in the ten year example, may cause a bigger loss and take the 12% Guy below the 4% Guy. You’re still in the game, however, and of course you can have losses in multiple years to more than 50%. This is true for either of us. Losses in multiple years is quite possible for both. Learning to hedge the risk to the downside will go along way, WHEN this bull market is over.
I wanted to bring up is the 4% Guy is also taking a bigger hit on inflation. A Consumer Price Index, CPI, of say 3% and an earnings of 4% really is not netting you much money. The 12% guy wins big in an inflationary environment. Now, just because we’ve been in a non-inflationary environment since about 2006 2007 doesn’t mean that it’s not going to happen again. In fact, I think were on the precipice of inflation and that’s why the Fed is raising interest rates and as of this recording on December 15, 2017. The Fed just raised interest rates another quarter point in the December meeting. Were in that window where they have to start regulating inflation with increased interest rates. That will become a bigger factor for the 4% guy moving forward.
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