The answer is pretty simple, “nothing.” This is a risk/reward business. The more risk you are willing to take, the more potential you have for significant rewards. The opposite is obviously true as well. The less risk, the less the potential for reward.
In other words, the safer the investment, the less money you will make in the long run.
This is just an efficient market at its best. Investors get rewarded for taking risk. And therein lies a serious problem for investors. If we all know that historically the more risk you take, the more money you make, it follows that to make more money we simply have to put our money in higher risk investments. It happens all the time.
I’ll tell someone that, based on their risk tolerance, they should be in a group of investments that is expected to return approximately 10 percent per year over the long run. The problem is that the client needs to earn 14 percent per year on average. Their next step is to do what any good, red-blooded American would do; they change their risk tolerance so they can buy the investment plan with the higher return potential.
That’s when investors start to get in trouble. You can’t change your risk tolerance overnight. It usually takes years of education to make that kind of change. You can’t pretend to be something you are not. It won’t work and your investments will suffer for it.
I had a client tell me last year, “I don’t mind taking risk … as long as my investments go up.” I have thought about this for a while, and I don’t know anyone who would disagree with that. Unfortunately, it doesn’t work that way. What goes up will come down and if you are in an investment that isn’t suited for you, you will do the wrong thing.
You don’t have to go far to see an example. Let’s look at Microsoft in a hypothetical situation. Let’s say that we have two investors who want to buy Microsoft at $50 per share in the first week of October 1998. One investor has a high tolerance for risk and the other does not but has read a lot about Bill Gates and wants to participate in the tech boom in the markets. By the end of January 1999 their investments are up to almost $90 per share and they’re both pretty happy. During 1999, the investment rises and falls often, but both investors still own the stock, neither thinking of selling during the downturns because the price never gets close to what they paid and it’s such a good company.
The company tops out the last day of the year in 1999 at just under $120 per share and both investors are ecstatic. In the first two months of 2000, the stock goes from just under $120 per share to $90 per share, but bounces right back up to $115 and everything is fine. Then the bottom starts to fall and Microsoft goes from $115 to $60 by the end of May 2000.
Now we start to see a difference in the investors. The high-risk investor knows that this may happen and is still comfortable waiting it out. The low-risk investor, on the other hand, is getting very nervous. He thinks about selling, but he still owns his shares at a profit and he starts to pray that the shares will go back to at least $100 very soon. By July 2000 the stock has rallied back to the mid-80s. Our high-risk investor decides to get out of half his shares at a very nice profit, allowing him to get his original money out while still owning some shares.
The low-risk investor thinks of what he could do with the money if it just got back to $100 and he prays harder. By the end of the year the stock has plummeted to $42. The high-risk investor, with almost no original investment left, continues to hold the stock. The low-risk investor can’t take the pressure any longer and sells his shares just in time to get a tax write-off on the loss he took, having held his stock for just over two years and earning a return of minus-16 percent.
Unfortunately, he missed the rise in 2001 to its current price in the mid-60s.
Two investors owning the same stock for the same time frame with startlingly different results. The moral of this story is, “If you step outside your risk comfort zone’ when you invest, you will not be able to make the decisions required to do well.”
When people like me say that higher risk investments pay more, it’s only true for the investors that can handle it. For those that can’t, it can be a disaster. I’ll end with a quote I never thought I would be able to fit into a financial column, “Don’t do the crime, if you can’t do the time.”