My wife and I recently visited a small, hole-in-the-wall Mexican restaurant. Mexican is my favorite kind of food with street tacos taking the top spot, so I like to try new places when I can. We ended up having a great experience, but that’s not always the case. With most of these small shops, there are only a few reviews so you don’t know exactly what to expect going in. You might get one of the best meals you’ve had in your life, or you can be thoroughly disappointed and you might spend the next day locked in the bathroom. High risk, high reward.
I contrast this with the experience I have going to Chipotle. I’m not a big fan of Chipotle, (sorry to all of the Chipotle truthers out there) but I think it’s solid. It’s never going to knock my socks off, but it will never be the worst meal I’ve had. It’s consistently good and I know what to expect every time I go. I guess, depending on the day, there’s still a risk of spending the next day in the bathroom. But overall, lower risk, lower reward.
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This same principle that applies to picking Mexican restaurants is also a fundamental principle of investing: risk and return are linked. You can’t have one without the other. You cannot receive a higher return on your investment without increasing your risk as well. While this should seem intuitive, there are plenty of people still being tricked into buying investments that promise a high return on investment with zero downside risk. A guaranteed, high return investment doesn’t exist.
With investing, instead of the possibility of a bad meal or an upset stomach, risk is the possibility that you could lose money or not achieve your desired return. Simply put, risk is uncertainty. There will always be some form of risk when it comes to managing your money. Even if that risk isn’t apparent right now.
For example, let’s say you’re hesitant to invest your money because you can’t stomach the possibility of losing it. So, you just save up cash — no possibility of a return, but there’s no risk of loss. As it turns out, not getting a return can be pretty risky too. All of the money you’re stashing away is actually slowly losing value due to inflation as time goes by. Based on historical inflation, $1,000 today would only be worth about $670 twenty years from now. By not investing your money, you’re risking not being able to retire or fund other future financial goals.
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There’s no way to completely get rid of risk, because as Carl Richards puts it, “risk is what is left over after you’ve thought of everything.” But there are ways you can try to minimize and manage it properly.
The following graph shows the likelihood of receiving a positive or negative return based on a specific time frame. I’ve always found this data to be astounding.
As your investment horizon lengthens, a diversified portfolio becomes progressively less risky. Does this mean you’re guaranteed a certain stock return if you hold them long enough or that these same results are guaranteed to be repeated in the future? No. Investors should think in terms of probabilities, not guarantees. But the closest thing to a guarantee that I know of is a diversified stock portfolio, held for a long time.
So why doesn’t everyone do this?
The short answer is it’s not easy to stick to the plan. While the data tells us that long-term investing has a high probability of success; day to day and year to year market movements are unpredictable and seem anything but certain. However, short term uncertainty is the price to pay for long-term investing success.
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There is no right or wrong amount of risk. It’s a personal decision that should be based on your financial goals, risk tolerance, and expected return. All investments involve some degree of risk, it’s up to you to decide what you’re willing to accept. Do you want to find a hole-in-the-wall restaurant in search of a fantastic meal, or are you comfortable with the certainty of Chipotle?
Thanks for reading!