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One needs to think twice before investing too much money into volatile stocks and mutual funds. We all want to own stocks and mutual funds that increase by fifty percent in a year while the market does it typical 12% (average returns have been much higher for the recent decade ). What one has to be watchful for is not losing money or "preserving your capital" since it is harder to make money back once it is lost. Taking risk is fine, but one must measure that risk against a total portfolio risk. Just like asset allocation, allocation of risk is important to a good investment strategy
It is mathematically harder to make money than it is to lose it. Consider a $1,000 investment in a stock that goes down fifty percent in year one and then goes up fifty percent in year two.. You will not be even after two years, rather you will be down 25%! 0.50 x $1000 = $500 What if the investment goes up the first year fifty percent and down the second year the same fifty percent? 1.50 x $1000 = $1,500 Either way you look at it, you lose money big time! I believe this is one reason the stock market pays so well for consistent earnings growth and punishes so heavily when companies come up short of analysists estimates for income. Consistent growth is so much better than alternating good and bad years as my simple example shows. For the individual investor, the lesson to learn is to not take so much risk that you might have a year of significant relative negative growth in your portfolio. Investment Risk Pyramid I was taught when I first started investing by a commissioned broker that one builds a portfolio of risk that stacks up like a pyramid . A smart investor allocates the risky investments weighted like the top of a pyramid (maybe 5% in a volatile sector or stock), the very secure investments weighted like the base of a pyramid (40 to 60% invested in large cap blue chip stocks and B or Higher rated bonds) and intermediate risk as the center of the pyramid. This pyramid structure gives you a base of good growth and returns no matter how well your risky 5% does and you hope you break even or better on the middle of the pyramid. Go To Page: 1 2 |
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