Understand the Risks of Investing

2 months ago JCprojectfreedom 0

As individuals, we have little or no control over the investments made with our money in the stock market. I want to introduce the three states of money.

  1. Spend your money
  2. Lend your money
  3. Invest your money

Spending incurs more than the cost of what you buy. Once spent, the money can never again earn a return, which is defined as “Opportunity Cost”. Lending is what most people end up doing, unwittingly with their money as they deposit their earnings in a bank checking account, thus lending the bank their money at 0 percent interest. If we buy bonds and make deposits into our check and saving accounts, we are getting terrible rates of return.Finally, investment means ownership and presume some rate of return and increase in value. There is no perfect investment and I will suggest that you learn some fundamental strategies to improve the odds of winning this game.

  1. Risk
  2. Drawdown
  3. Decumulation

Understanding Risk within Specific Investments

What is at risk is the loss of your money, and that is what you need to focus on when evaluating the risk of any investment.

  • Risk is like oxygen: it is invisible, everywhere and all around us.
  • We cannot ignore the influence and effects of risk
  • Too little risk and we won’t survive
  • Too much risk and it can explode
  • With proper amount of risk, we thrive

Investment has some risk associated with it. Most investors do not understand the risk and they ignore it altogether. With any investment, take time to learn about and understand the risk involved. It is always present, regardless of what the salesman tells you. Ask yourself, “If I experience the result of the risk, can I afford the loss?” If you can’t, then don’t invest! It is that simple. Your job is be aware of this reality and instead of blindly going into an investment, you need to make informed choices and decisions about what to invest in with your money.

Drawdown is defined as the historical loss of an investment is calculated by subtracting that investment’s lowest value from its highest value over a market cycle. It is important to note that the recovery from drawdown is not linear, which is why the average rate of return of an investment can be markedly different from real rate of return.

Here is a math question. Take an investment and increase its value by 50 percent then lose 50 percent of that investment. What’s left?

50 percent increase in value – 50 percent loss in value = 0 percent average rate of return

Therefore if I invested $100,000 into this strategy, I made some money and lost some money, but at the end of the day, I would still have $100,000?

$100,000 x 50 percent = $50,000

$100,000 + $50,000 = $150,000 (50% gain)

$150,000 x 50 percent = $75,000 (After 50% loss)

I will left with $75,000 in my brokerage account, my real Rate of Return would have been a negative 25 percent instead.

JC Project Freedom Recovering from drawdown losses

The above table is a great way to illustrate what is the effect “Drawdown”.

It is more reasonable to accept more risk when you are younger because with more time to recover, the returns can be much smaller. A 50 percent loss would only require a 3.3 percent ROR to fully recover over 30 years.  Let’s say you were about to retire in 2008 and the market crashed. You could have lost 50 percent of your retirement nest egg right before you planned to access that money. Many people did find themselves in exact situation and had to postpone retirement.

Decumulation

A condition whereby investment withdrawals occur while, simultaneously the principals remains invested. Therefore, as withdrawals are made there is still potential for ongoing gains. There is also the risk of ongoing losses.

Sequence of withdrawal risk – if an investment is not protected from losses while withdrawals are made during a down market, that investment is subjected to profound negative effects, which are exacerbated by those withdrawals. If one takes withdrawals and simultaneously experience serious losses, then there is very little chance of recovery and the investment will likely be depleted entirely over a relatively short period of time.

Simply, never choose to retire immediately prior to a market downturn. We know that it really does not matter when you start investing in the stock market because given time, and if you don’t have to make withdrawals, you will make money in the stock market.