What you need to know to invest

Understanding risk and how it relates to three different ways to grow your money is key

Sarah Newcomb 29 October, 2019 | 1:43AM

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Why invest? Because every year, things cost more and more and more, which is why it’s so hard to keep pace with the cost of living if you’re relying on savings alone to build your nest egg. What cost $1,000 20 years ago costs more than $2,000 now, and in a couple dozen years, it will be double that. As a friend recently observed, “I remember when a truck cost $10,000. Now that’s the discount they advertise in promotions.”

Inflation may be better than deflation, but it’s still a pain in the neck. The tiny amounts of interest you can earn from savings accounts aren’t enough to keep up, so as weird as it sounds, saving your money is a guaranteed loss. If you want to grow your savings, you’ve got to invest it, and that means facing some hard trade-offs between risk and return.

The booby trap
You’ll hear a lot of people cite the rule-of-thumb “More risk; more return,” which is a simplistic misunderstanding of the risk-return relationship--and a dangerous mental booby trap. If higher risk always meant a higher return, then it wouldn’t actually be risk!

No. Higher risk means higher risk. You may see a high return, but you may also lose your shirt.

Think about it this way: Imagine two friends each ask to borrow $1,000. One of them has borrowed money from you before and didn’t pay you back. The other paid you back early. Which are you more likely to lend to? The one with the good track record, of course. Now, what if the person who defaulted on you earlier promises to pay you back double what they borrow. You might be enticed to make the deal because you could make a significant return. The extra they promise to pay you back is meant to compensate you for taking on the risk of giving them money in the first place. That’s the risk-return relationship. Higher risk means higher risk of loss, with a higher return if you get your money back at all.

So instead of “more risk; more return,” there’s a better rule of thumb that can help you protect yourself from taking on too much risk, while still outpacing inflation.

Different games with different rules
When it comes to growing your nest egg, you basically have three options: lending, investing, and speculating. Each of these strategies has different amounts of risk associated with it, and different potential for gains and losses.

Lending is when you enter a contractual arrangement to give your money to a third party on the condition that they pay you back, with interest, by a specified date. When you lend your money, the risk you face is that you might not get paid back. Generally, the more likely the borrower is to default, the more you can charge in interest as a way of making it worth your while to take on the risk of lending to them in the first place.

You can lend your money to the government, banks, corporations, and individuals, and each of those options poses some risk, with the government having the lowest risk of default, and individuals the highest.

Some options for lending include:

Government -- Treasury bills and bonds
Banks -- Savings accounts, money market accounts, CDs
Corporations -- Corporate bonds
Individuals -- Private agreements between individuals

When you lend your money, there is (usually) some sort of formal agreement for paying you back. That’s why lending is the safest way to invest, relatively speaking.  However, since you don’t have as much risk of losing your money by lending, you can’t earn as much in return. Government bills and bonds often don’t even keep pace with inflation, so pay attention to both the annual return (annual percentage rate) on the money and the predicted inflation rate. If the inflation rate is bigger than the APR, then you’re still poorer at the end of the deal.

Speculating is when you buy things without knowing much about their future value. When you speculate, you might win big--but you can also lose big. That’s why it’s not smart to speculate with money you can’t afford to lose. Consider speculation for fun and potential extra money, but not for the bread-and-butter of your future income.

Some options for speculating include:

Playing the market -- Individual stock picks, junk bonds (deceptively called high-yield bonds), penny stocks
Lottery -- Casinos, lottery tickets, fantasy football
Uncertain futures -- Cryptocurrencies, blue-sky technologies, your brother-in-law’s startup

All three of these strategies have pros and cons. The safer strategy of lending to banks and governments comes with the trade-off of lower returns that might not even match inflation. Investing for the long term requires research, self-discipline, and patience, which can be challenging for us all, and there is still the risk of losing money in the end. Speculation can turn people into millionaires or paupers overnight, and it offers an added adrenaline kick that many of us crave.

What it means for you
How do you know which strategy to use with your money? The simple answer is to do a little of all three, but how much to put toward each depends on your needs and your time horizon.

For money that you can’t afford to lose and money you will need in the short term (say, in less than five years), consider lending to the government and banks. You won’t earn much, but you won’t lose it, either--and inflation doesn’t have much time to eat away at it, anyway.

For long-term goals like retirement or your kids’ college, consider investing. A simple investment portfolio made up of well-diversified assets like those offered in mutual funds and ETFs is likely to outpace inflation without putting your money at unnecessarily high risk.

For fun and extra money, speculation can be a great strategy. Casinos are popular for a reason, and certainly there is potential for making a lot of money if you are able to predict stock prices correctly. However, speculation can be the enemy of long-term security, so don’t speculate with money you can’t afford to lose.

The smart shortcut
With all this in mind, what’s the rule-of-thumb you can take with you today? It’s pretty simple.

Lend for secure, predictable returns in the short-term (less than five years).
Invest for long-term, diversified growth (five years or more).
Speculate for fun and potential extra money.

Remember that higher risk means higher risk. Don’t speculate with what you can’t afford to lose, and if you are entrusting your money to a financial professional, make sure that they are not speculating with your core savings.

About Author

Sarah Newcomb  Sarah Newcomb, Ph.D., is a behavioral economist for Morningstar.