Posts Tagged ‘retirement planning

29
Mar
12

Risk & Reward

We all know the age old rule that the more risk we take, the higher the potential reward.  And we tend to think this relationship looks something like this:

We tend to think the relationship between risk and reward is linear.   In other words, for an additional amount of risk we take, we are compensated a proportional amount of reward, with no limit on the amount of reward we can reap.  This is common thinking when describing the Risk/Reward balance.

If we were whipping up charts to model our ideal Risk/Reward relationship, this is what we would want.

This way, we are compensated exponentially over the long term for taking more risk.  And, just as with the linear chart, there is no limit to the amount of reward one can reap.  Sadly, neither of these are the case when it comes to the stock market.

We are more likely to see diminishing returns for incremental risk that we take on.  Something like this:

Eventually we run into an asymptotic behavior, when we go out to infinity with our risk, the reward will seize rewarding for that additional risk.

So, when people say, “more risk = more reward,” stop a moment and think how you are being rewarded.  Is it in proportion to the amount of risk you are willing to take?  Will you be exponentially rewarded for your risks?  Will you take additional risk that barely return you more reward?

Food for thought.  What’s your risk/reward relationship?

22
Mar
12

Reaching For Yield

We once upon a time knew a young women who was getting married in the Spring of 2009.  She and her parents had saved a good chunk of change for the wedding through equity investments, and they made the mistake of budgeting the wedding based on the valuation of the funds at some peak around 2008.  Well, since they continued to think they could reap the same returns, which quite frankly they were lucky to have in the first place for such short-term needs of the funds, they left their money in stocks.  Everyone knows the rest of the story, the girl’s wedding was ruined, she had to buy out of contracts she was already in, change venues and cut back the list of guests.

Their mistake?  They were greedy and wanted more return for their money in the short term for risks they didn’t want to shoulder.  Sometimes people get away with this and they squawk about it at parties.  When they get burned, you are unlikely to hear a peep about their finances.  And while cutting back a guest list isn’t the same as paying a mortgage or putting food on the table, the mistake was a classic, often repeated and common one.

Reaching for yield is what we are talking about, and it is a viral theme often preached as being acceptable in today’s 20 something and 30 something blüg-o-sphere.

We know the fundamental investing principal of “Risk = Reward.” The greater the risk we are willing to take, we are potentially rewarded more.  Reaching for yield is when you veer from your investment plan and take on a greater amount of risk than you are willing to accept for a bucket of funds hoping for greater returns because you think the yields are unacceptable.

What makes a yield unacceptable?  We’ve heard a variety of reasons: the value of cash is being eroded by inflation to a friend getting lucky with junk bonds to thinking one can get ahead without getting burned.  Whatever the reason, reaching for yield, or going up the yield curve can put one’s plan in danger.

More money has been lost reaching for yield than at the point of a gun

-William Bernstein

Just as our bride friend above, a person reaching for yield can find the money they need to be gone when they need it.  Emergency funds are something where we should accept whatever the FDIC savings rates offer.  Whatever you decide on the amount of money you need for an emergency, you never know when you’ll need it.  An emergency, by definition, is an event you don’t plan on happening.

Reaching for yield with emergency funds isn’t the only example of reaching for yield.  Funds being saved for a home down payment, holding too many equities & not enough bonds, using peer-to-peer lending to replace fixed income allocations, etc.

We know the rates on FDIC insured saving vehicles are relatively low compared to 6 years ago and there are fears of inflation eroding the spending power of money away.  We wish inflation was moderate and predictable, we wish savings accounts were yielding 5-6%.  But, it isn’t in cards today without accepting greater risk.  We just hope people will think of the needs for their money and not find their money consumed by the market when they need it.