Paly Enterprises

Financial Independence Fundamentals

How Much Risk Will You Take?

by: Daniel P. Matthews

Everyone is willing to take risk - as long as they don't lose anything! But, some people are willing to lose everything if they stand to gain enough. That is the pickle you face in deciding how to invest your money.

On the one hand you could convert all your money to cash and carry it with you. You might think that would eliminate your risk. It does not. You could get mugged, everything would be lost. If you don't get mugged and you carry it with you, you earn no interest and that means you do nothing to offset the effects of inflation. And of course inflation causes your money to be of less value every day. So, carrying your money with you doesn't seem prudent.
On the other hand you could invest your money. Savings banks, for example, will pay you interest at 1 or 2 percent. Certificates of deposit can stretch your return something greater than a bank's savings account, but not by much. As long as the inflation rate is lower than the interest rate the bank pays you, you are increasing your money. But, rarely is that the case.

Most banks are low risk - generally, your money is safe. Still, you should be mindful that banks have failed - as a matter of fact in the 1980's many banks went under! Yes, the federal government's insurance program helps to restore your savings if a failure occurs but there are limits as to how much the government will restore. If you are over that government imposed limit, all funds above that limit is lost.

But, you want your money to grow as quickly as possible. A bank's interest rate is incredibly low. Risk is driving your decision to accept the bank's incredibly low offer or investing your money with them. To be sure, the money in an insured savings account is "liquid"; meaning you have access to it nearly "on-demand".

Here are some key elements that drive people to be more risk tolerant than other people:
— The first element is age. The younger you are the more time you have to recover if an investment turns sour. The older you are the more likely it is that you want a consistent flow of income. Your desire for current income tends to make you more risk averse.
— Why does age and time have this effect? Our model helps demonstrate the point. Remember, our model established a goal of $5,200/year in additional income. If you held money in a savings bank and that bank paid 3% on your money, you would need $173,335 in savings to generate the desired $5,200 annual income. The need for that annual income is soundly met by the savings bank scenario just discussed. However, you need to understand there is still an amount of risk in the scenario.
— The Government more than likely insures your savings account up to $250,000 (double for joint accounts). You would have to manage the risk of having more in the savings account than is Federally insured. One way to mitigate that risk can be by opening another savings account at a different bank and splitting the money so neither account has more than $250,000. But, there are other ways to manage that risk too. Using your savings account for short term needs is a sound approach and putting the rest of your money to work for you in other investment types is an approach that can bring greater rewards, but carries some other risks. Those risks too can be managed.
— Another factor that drives risk tolerance is how you feel about certain outcomes of financial transactions.
— Your reaction to the potential outcome of a financial transaction is reflected in the way you buy car insurance. Do you buy the minimum amount of car insurance and trust that things will work out? Do you buy the maximum amount of car insurance and sleep comfortably knowing you're covered? Do you trade-off the monthly insurance payment with the amount of the deductible? The answer to these and some other questions will help you understand whether you are a risk taker or a risk avoider!
— Also, your experience with investing can drive your risk tolerance.

People who understand stocks, bonds, mutual funds, real estate, etc., are more likely to consider the return that these investments can produce. Without experience, you do not know the possible outcomes of these types of opportunities. Without the experience, you are apt to ignore them all together. The solution is to reduce this risk through learning about the opportunities, then using them, when appropriate, to your advantage - to get a higher return than the bank pays on your savings.

Real estate and brokerage accounts are two methods often employed to garner greater rewards than the measly interest paid on savings account. Nowadays you can watch all manner of real estate investing on reality TV. Most likely you have done a micro version of this with your own home. The advent of web based vacation rental programs makes seasonal renting something just short of ubiquitous. In every news report the investment reports are given quoting the days performance - whether the markets (Dow, NASDAQ, S&P, etc) went up or down. The indicators reveal broad movements in the market made up of collections of individual stocks and or bonds daily performances. Okay, here are two final thoughts. First, take a short visit to British Columbia Securities Commission Risk Tolerance site and answer some questions to figure out your risk aversion level.

The second thought is about the earlier discussion referring to savings banks. Savings banks used to give personal loans for 8, 9, 10 percent. Now, they issue credit cards for 15, 18, 20, even 21 percent and more. They pay you an incredibly low savings interest rate and charge you fifteen or more percent! That means they are making 10 or 13 percent, even more, on the money in their bank! If banks can get that kind of return, so can you! Yes, you can! Minimize the amount of money you have in banks to the money you need short term, six to twelve months. You know, paying bills, sudden emergencies, etc. Put your money to work for you, not the bank!
The annual inflation rate for the past ten years indicates the investment return rate you must "beat" to ensure your money is growing:
  • 2012 - 2.1%;
  • 2013 - 1.5%;
  • 2014 - 1.6%;
  • 2015 - 0.1%;
  • 2016 - 1.3%;
  • 2017 - 2.1%;
  • 2018 - 2.4%;
  • 2019 - 1.8%;
  • 2020 - 1.2%;
  • 2021 - 4.7%

and thus far in 2022 it is 8.3% annualized (the average of January through August 2022). Simply put, if you are not making more than 8.3% reward on your money thus far (September 2022) you are losing money!

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