Financial Planning - Risk Vs Reward "Risk" is a term we hear so often, and yet not many of us really know what it really means. Usually, we all think about "risk" as losing money because of a bad investment decision or the economy tanking, like we've all seen happen to our houses.
Financial PlanningAnd sure, this kind of risk is real, yet it is not the only type of "risk" that's available, potentially waiting to hurt your security. Also, just about everyone has an understanding that usually, (but not always) the greater "risk" you take, the higher the potential reward. You realize, like investing in your brother-in-law's "can't miss" pay phone business, or going short on gold futures on margin. You can find killed, but if the deal works, you can find rich.
This rule is pretty solid, but is not always the case. For instance, let's discuss the only risk you might be taking, that violates the rules of risk/reward. A risk, the most common risk we see people taking, and that offers a much greater chance of loss, without the equally greater chance of making money! What risk is? The risk of NOT BEING DIVERSIFIED! Let's explain the easy concept of diversification. It is simply the concept of not putting all your eggs in a single basket!
We know this seems like a kindergarten lesson, but please bear with us.Even though being diversified sounds like a basic foundation of your investments, Let me tell you that over 90% of the clients we have seen are so poorly diversified that they're at great risk!See, if you have most or all your money tangled up in the company you work for, for example, you are at great risk! We have seen people all the time who work with a company, have all of their insurance benefits with the company, have their profit sharing plan from the company, and own a lot of the company's stock both personally as well as in their 401(k) plan or whatever! Or, putting all your money in the market as a whole. We still consider this as one investment, if that is all you have, even If you have many stocks inside your portfolio. If your company or even the market as a whole sucks wind, you are at great risk!
Does any of this mean more to you considering the 2008, and 2011 stock exchange roller coasters? There is little if any potential reward for this family to keep their whole financial security tied up in this one company, a treadmill type of investment.So many people are, taking all equally high potential of reward!
This insufficient diversification can be the most deadly risk you could ever take!You must be realistic in your assessment of how you're diversified. You cannot think you're safely diversified for those who have money in six different banks! While you've diversified amongst banks, you aren't DIVERSIFIED AMONGST TYPES OF ASSETS!
SuperannuationSee, true diversification includes being diversified by the different kinds and forms of investments! For instance, someone who has money split up between bank CD's, annuities, life insurance coverage cash values, stocks, bonds, real estate, foreign instruments, etc., etc... is true diversification!
Let's look at an example of how separating your money into different asset types could add incredible safety!Assume some investor has $100,000 to get, and one option was to place it into a relatively low risk, low yielding account, and in the other case, splitting up into five $20,000 chunks.
And, let's assume that two of the five investments in the diversified option don't make any money, and the other three do as shown.Invest $100,000 @ 4% For 20 Years = $219,112 Compared To Diversifying Over Two decades:
Invest # 1 - $20,000 @ Total Loss = 0
Invest # 2 - $20,000 @ 0% = $20,000
Invest 3 - $20,000 @ 5% = $53,065
Invest # 4 $20,000 @ 10% = $134,550
Invest # 5 - $20,000 @ 12% = $192,926
TOTAL $400,541
Fee for ServiceWould you see how, even though one investment was a total loss, and one made nothing, this investor still made more income by diversifying! (NOTE- THIS IS AN EXAMPLE Just for ILLUSTRATION PURPOSES, AND IS NOT Supposed to have been MAKING ANY PREDICTIONS OR PROJECTIONS. NO RETURNS ARE IMPLIED OR STATED.)