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Lessons on Potential Risk and Reward

by Kevin McKinley - January 10th, 2016

Posted Under: investing

The beginning of the new year is as good of a time as any to take a look at your finances.

In light of the current economic and investment climate, you may want to start a review of your portfolio with a remedial lesson on the math of potential risks, and potential rewards.

The market giveth, and taketh away

Over most of our lifetimes, owning a diversified portfolio of high quality common stocks or mutual funds has often delivered a satisfactory return over the very long term. Declines in these types of investments have usually been relatively short-lived.

We certainly hope that environment continues far in to the future. But if it doesn’t, some investors may learn about the “50/100” rule of performance.

That is, if your investments have a hypothetical decline of 50%, you need a subsequent return of 100% just to get back to your original return.

After a significant decline in the future, any ostensible ride back up might not be as swift and sure as they have been in the past.

And your ability to endure the next decline might be hampered by the need to live off the investments during retirement or unemployment.

The tortoise and the hare

Many of us have come to accept potential declines as an unfortunate drawback to earning higher potential returns. But an exercise that slow and steady may not only win the race (or at least be competitive), it may also help you sleep better at night.

Say you have two hypothetical portfolio options: “A” and “B”. Over a five-year period Portfolio A will provide a guaranteed 3% return every single year.

Over the same five years, Portfolio B will offer a 10% annual return in four of the five years, but a 20% decline in the fifth year.

Common sense says that Portfolio B will still provide the superior rate of return. That’s true, but not by much.

Portfolio A gives you an “annualized” return of 3%. Portfolio B’s annualized return is about 3.2%, and that’s only true if you’re strong enough to stomach the 20% decline year to get the future 10% annual return years.

“Safe” may not be so sure

Perhaps like many investors you have already recognized the potential risks of stocks and stock mutual funds, and decided that the relative security of bond mutual funds is a better option.

That has been generally been the case in recent years, and again, hopefully will continue in the future. But bond funds may be facing potential threats as well.

One of which is rising interest rates, which may reduce the attractiveness of existing bonds, and lower the market prices of the securities, whether you own them individually or in mutual funds.

Another possible hazard is a stagnant or declining economy, which may make the bond issuers less able to pay the interest owed to the bond buyers. In some cases this could lead to a default, and the bonds in question could be worth pennies on the dollar.

How might a decline in a bond mutual fund affect you? Let’s say you put $10,000 in to a fund that paid interest to you of 4% per year (a relatively attractive rate in the current environment).

But due to one or more of the aforementioned factors (or other unseen events), after five years the value of your bond fund has experienced a relatively reasonable decline of 10%, so that the current value is $9,000.

At that point, your net annualized rate of return would be closer to 2%–a rate that could be obtained from investments offering less potential fluctuation and uncertainty.

Next week

Now that you’re suitably alarmed, we should talk about the ways to determine how much reward you “need”, and how much risk you can stand.

In the meantime, for this week, this year, and beyond, it may be a good idea to adopt an attitude of fearing the worst, but hoping for the best.