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It is an undeniable fact that investing involves risk. The reason stocks have a higher expected return than bonds is because investing in the stock market means taking on risk. We spend so much time focusing on investment risk that we forget the ironic truth about risk which is that Avoiding risk is the greatest risk of all.
Risk can’t be eliminated
The first thing to know about risk is that there is no way to avoid risk. It can only be managed. You can avoid investment risk by refusing to invest in the stock market or other “risky” assets. In doing so, you simply trade investment risk for what I call “opportunity-cost risk”.
Opportunity-cost risk is the risk of losing out on years of compounded investment returns that you would have earned had you invested your money more aggressively. Every decision has an opportunity cost. By taking certain actions to avoid one type of risk, you simply introduce a new type of risk.
I repeat, risk cannot be avoided it can only be managed.
To manage risk, we need to know which risks to embrace, which risks to avoid, and when. The most important factor when deciding how to manage risk is our time horizon. When do you need this money? In the short term (within a few years) or the long term (within a few decades)?
Managing short term risk
If you are saving money for a short-term goal like buying a house, buying a car or building an emergency fund then it makes sense to focus on managing your investment risk. These are situations where the potential reward of investing is simply too small relative to the risk.
If you have $10,000 saved up that you want to put towards buying a house in the next year, what would be the risk-reward proposition of investing that money in the stock market?
The most likely best-case scenario would be a solid year in the market, where you make a 10% return on your investment. You just turned $10,000 into $11,000. That extra $1,000 might come in handy to cover some minor renovations or to help furnish your new home.
The worst-case scenario would be a market crash in which your $10,000 investment drops to $5,000. In this scenario, you may not have enough for the down payment and miss out on buying that house altogether.
Is $1,000 worth risking the opportunity to buy a house? I don’t think so.
In the short term, our investment risk should be close to zero. The added benefit of having zero investment risk in your short-term money is that you have limited opportunity-cost risk. It’s not likely you’ll miss out on huge investment gains with a 1–2-year time horizon.
Your goal should be to eliminate investment risk with short term money.
Managing long term risk
If you are saving for a long-term financial objective such as retirement you need to embrace investment risk and manage your opportunity cost risk.
This is assuming you are investments are well diversified in something like a low-cost index fund. If you are investing in individual stocks, the performance of those stocks is something that needs to be monitored closely.
The worst-case scenario in the stock market is another financial crisis like we saw in 2008–2009. So, let’s use that as an example to demonstrate why investors with a multi-decade time horizon should not be concerned about the day to day movement of the stock market.
Let’s say you invested $10,000 in an S&P 500 index fund in October 2007, which was the peak of the market before it crashed.
- Over the next 15 months, your portfolio would have lost 53% of its value.
- By February 2009 you would have less than $4,700 left.
- Today, if you simply held onto your original investment you would have $18,700 (87% return on investment).
- If you reinvested your dividends back into buying more units of the index fund you would have $23,600 (136% return on investment).
In this example, even though we invested at the “worst possible time” we came out with twice as much money over 12 years by investing in the market versus “playing it safe” and keeping our money in cash.
The market rewards long-term investors
Over a 30-year time horizon, what is the opportunity cost of keeping your money in cash compared to investing in the stock market?
- $10,000 was added to your savings per year.
- Your average return on investment was 7% in the stock market.
- You Received a 2% interest rate on your savings account.
After 30 years,
- You would have over $1 million if you invested in the stock market.
- You would have $414,000 if you kept your money in cash.
- Your $1 million in stocks, $300,000 would be made up of your contributions and $700,000 would be made up of investment returns.
- Your $414,000 in cash, $300,000 would be made up of your contributions and $114,000 would be made up of interest.
To avoid the “risk” of investing, you would have given up $586,000.
So, I repeat, the ironic truth about risk is that avoiding risk is the greatest risk of all.
Putting it All Together
I am not advocating that you dedicate 100% of your retirement savings into the stock market. I am suggesting that you weigh investment risk based on your investing time horizon.
The longer the time horizon the less you need to worry about investment risk and the more you need to worry about opportunity cost.
The reverse is also true. As you get closer to retirement it makes sense to lower your investment risk as your time horizon is shrinking.
How do you manage risk in your portfolio? Do you consider your time horizon when choosing your investment allocation? Let me know in the comments.
About the Author
Ben Le Fort
Hi, my name is Ben. I am the founder of Making of a Millionaire. I have been obsessed with personal finance and learning how to manage money, ever since my parents declared bankruptcy and lost the family home to foreclosure in 2010.
I spent the next 10 years continuing my journey of educating myself about money. This education was both formal and informal.
On formal education, I earned a Bachelor’s and a Master’s degree in Finance & Economics.
On the informal side, I consumed every book, video, blog post, and podcast that discussed personal finance.
Education was nice, but it wasn’t until I began implementing what I learned that I began feeling more hopeful about the future.
Before long, I had paid off my first loan. Then the next. By 2015 I was debt-free. By 2016 my wife and I bought our first house. Then we started investing. We bought another house and began building real wealth.
As our wealth grew, the memories of that family bankruptcy seemed further and further in the rear-view mirror. My stress and anxiety began to melt away and I was able to sleep at night without my mind racing and problem-solving.
By 2018 I knew it was time to start sharing what I learned about managing money and Making of a Millionaire was born.
I hope you find the articles, videos, and courses created by Making of a Millionaire to be of value to you. Please feel free to reach out to me directly if you ever have feedback or questions.
You can read all of my articles on my personal site, or on Medium. If you’re interested in video-based personal finance tutorials and education, you can Subscribe to my YouTube channel or check out my in-depth personal finance course.
Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.