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Investing vs. Speculating: Risk Management Tips for Investors Thumbnail

Investing vs. Speculating: Risk Management Tips for Investors

People seem to have more time and disposable funds on their hands. As a result, a new breed of retail investors has emerged, further fueled by the COVID-19 pandemic and the growth of digital trading platforms including Robinhood.

According to a Deloitte Center for Financial Services report, an estimated 10 million Americans opened new brokerage accounts in 2020. Another 6 million downloaded a trading app in January of this year and about one-third of the accounts have balances under $500. There’s increased attention to the growing role of retail investors with rising trading volume, speculative trading and market functioning. Thus, we find it timely to review risk management tips for novice and experienced investors alike.

I’ll use the wisdom from two highly regarded investment managers: Peter Lynch, who formerly ran Fidelity’s Magellan Fund and the “Sage of Omaha,” Warren Buffett, CEO of Berkshire Hathaway. 

“Know what you own and know why you own it.” - Peter Lynch

“Risk comes from not knowing what you’re doing,” and “Two primary risks investors should avoid at all costs: losing money and inadequate investment returns.” - Warren Buffett

Points About Risk

Risk/Return trade-off: Generally, higher returns come with higher risks and vice versa. While both high-risk or low-risk investments can be good or bad, what matters more are the overall characteristics of the portfolio and the probability of achieving the expected returns. Like Goldilocks, is the portfolio too hot, too cold, or just right?

Insufficient wealth: Not saving enough or having inadequate returns (i.e., being overly risk-averse, underperformance, not accounting for inflation, devastating losses, etc.) may lead to unsatisfactory outcomes.

Measuring risk: Volatility, or price fluctuation, is a measure, but not the only measure of risk. Generally, a portfolio with less volatility is preferred. However, a poor-performing investment with low volatility is still a poor investment. There’s a big difference between temporary and permanent price declines, and one’s “risk tolerance” is hard to measure and often shifts with age and life events.

Risk Management Tips

It’s hard to climb out of a hole: If your portfolio (or investment) suffers a decline, then you have to recover more than the decline to break even. If you’re down 10%, you need to grow to 11.1% to break even; if you’re down 50%, you need to double to recover. Recouping losses is more challenging when you’re retired and taking distributions. Point: Lose less when markets decline!

Use the powers of “compound interest” and “rebalancing”: Start saving early. Someone who starts saving at 25 years old may accrue about double the wealth of someone who starts at 35, simply because they started earlier. Assuming both save $5,000 annually until retirement, their accumulations by age 65, at a 6% return, would be about $773,800 and $395,300, respectively.  

Rebalancing is a great tool available in many 401(k) plans as it helps you capitalize on “sell high/buy low.” If your portfolio is to be equally allocated among three investments, two investments are up, and one is down. Rebalancing will trim the gainers and buy the cheaper investment.

Non-investment risks: Many factors can screw up retirement, education funding and other financial goals. Things like job loss, divorce, loss of a loved one, health conditions, living longer than expected and other life events can all have an impact. Therefore, keep a holistic approach in your financial planning and talk to your advisors for their objectivity, expertise and perspectives. They may help highlight potential “blind spots.”

Muhammad Ali, a world-class boxer and prominent humanitarian, once said, “He who is not courageous enough to take risks will accomplish nothing in life.” Life abounds with risks, and it’s easier to take them when you’re younger. However, whether you’re young or old, manage your risks prudently. 

May this sage advice help you invest wisely.

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