Risky Business

Mark Procino is typical of America’s conservative savers. A middle-aged electronics technician, he doesn’t trust the stock market. He faithfully contributes to his 401(k) each month, but he avoids any other investments in stocks. He has several certificates of deposit (CDs) and a small money market account at his bank. Mark doesn’t like risk, so he wants to keep most of his financial future in what he regards as “safe” investments.

Like other savers, though, he isn’t happy with the sickly return that he’s getting from these “safe” investments. With one-year CD rates at 1 percent or so, and money market accounts paying a fraction of a percent, Mark’s investments are actually losing money when inflation is factored in.

Even the safest of all investments, Treasury bonds offer little help. Recently, three-year treasuries are paying a little more than one percent interest. Like many Americans, Mark wants to find a safe investment that will pay more than CDs or Treasury bonds.

Good luck.

You have two choices: Keep your money in so-called “safe” investments where your return may be erased by inflation, or take a risk on investments that may pay you a much better return, with the understanding that you may lose money as well as make it.

In the professional investment community, this situation is described as the risk/reward ratio. In general, the greater the risk, the greater the possible reward. Each saver/investor has to decide his or her level of tolerance for risk and balance investments on that decision.

Most pros will agree that investment in stocks represents the highest degree of risk (with the exception of such exotic instruments as futures and commodities) but also provides the highest level of potential return. From 1926 through 2004, the 500 largest companies (as represented in the S&P 500 index) returned an average of 10.4 percent per year. Small company stocks did even better with an average return of 12.7 percent per year – the best rates of return of any conventional investments.

But don’t forget the risk factor. In some individual years during that extended period, stocks suffered losses in excess of 30 percent.

The lowest return of all during the period came from investments in cash or cash equivalents such as savings accounts, CDs or money market accounts. These averaged 3.7 percent per year.

The lesson in all this is that stocks offer the best probable return over extended periods of time. The younger the investor, the longer the investment timeline, the more likely investments in stocks will provide a healthy return. For older investors with shorter investment timelines, the greater the risk that one of those “bad” years will reduce or even erase the return.

So what about such “safer” investments as U.S. government bonds? Not bad. Over roughly the same span of 80-plus years, treasuries returned a decent average of 5.5 percent.

However, as was the case with stocks, there were individual years such as 1967, when soaring interest rates caused sharp drops in bond prices.

So what are investors looking for higher returns but concerned about safety to do?

This is where the principle of asset allocation comes in. Asset allocation is a key to successful investing, and refers to the division of investment money among various classes of investments, stocks, bonds, cash and cash equivalents appropriate for individual investors.

So, what is the best asset allocation for you? Should you have 10 percent of your portfolio in stocks, or should it be 80 percent or 90 percent, or something in between? What about the rest? Should you invest the balance in bonds, CDs or other cash equivalents?

That depends on several important variables. At the top of that list is your tolerance for risk. Next is your timeline. If you have many years before you must start drawing down your investments, you have time to ride out the inevitable dips in the market that cause stocks to fall in price temporarily.

Ultimately, though, the choice is yours. No one knows your investment goals and your tolerance for risk as well as you do.

The author is a freelance writer based in Abington, Pa. He has 40 years experience in business management and financing.