Investing lessons: There's no such thing as risk-free

April 1, 2010

You might say that Mark Procino is typical of America’s conservative savers. A middle-age electronics technician, he doesn’t trust the stock market. He faithfully contributes to his 401(k) each month, but he avoids any other investments in stocks. He has several certificates of deposit and a small money market account at his bank. Mark doesn’t like risk, so he wants to keep most of his financial future in what he regards as "safe" investments.

You might say that Mark Procino is typical of America’s conservative savers. A middle-age electronics technician, he doesn’t trust the stock market. He faithfully contributes to his 401(k) each month, but he avoids any other investments in stocks. He has several certificates of deposit (CDs) and a small money market account at his bank. Mark doesn’t like risk, so he wants to keep most of his financial future in what he regards as “safe” investments.

Like other savers, though, he isn’t happy with the sickly return that he’s getting from these “safe” investments. With one-year CD rates at 1 percent or so, and money market accounts paying a fraction of a percent, Mark’s investments are actually losing money when inflation is factored in.

Even the safest of all investments, treasury bonds, offer little help. At the time of this writing, three-year treasuries are paying a little more than 1 percent interest. Like many Americans, Mark wants to find a safe investment that will pay more than CDs or treasury bonds.

Good luck.

The inevitable risk

The cold truth in the world of investments gets down to two choices: Keep your money in so-called “safe” investments where your return may be erased by inflation, or take a risk on investments that may pay you a much better return, with the understanding that you may lose money as well as make it. In other words, there is no such thing as risk-free investments.

In the professional investment community, this situation is described as the risk/reward ratio. In general, the greater the risk, the greater the possible reward. Each saver/investor has to decide his or her level of tolerance for risk and balance investments on that decision.

Most pros will agree that investment in stocks represents the highest degree of risk (with the exception of such exotic instruments as futures and commodities) but also provides the highest level of potential return. From 1926 through 2004, the 500 largest companies (as represented in the S&P 500 index) returned an average of 10.4 percent per year. Small company stocks did even better with an average return of 12.7 percent per year - the best rates of return of any conventional investments.

But don’t forget the risk factor. In some individual years during that extended period, stocks suffered losses in excess of 30 percent - high reward, high risk.

The lowest return of all during the period came from investments in cash or cash equivalents such as savings accounts, CDs or money market accounts. These averaged 3.7 percent per year.

The lesson in all this is that stocks offer the best probable return over extended periods of time. The younger the investor, the longer the investment timeline, and the more likely investments in stocks will provide a healthy return. For older investors with shorter investment timelines, the greater the risk that one of those “bad” years will reduce, or even erase, the return.

Safer, but smaller return

So what about such “safer” investments as U.S government bonds? Not bad. Over roughly the same span of 80-plus years, treasuries returned a decent average of 5.5 percent. However, as was the case with stocks, there were individual years such as 1967, when soaring interest rates caused sharp drops in bond prices.

So what are investors looking - for higher returns but concerned about safety - to do? Where should they put their money?

This is where the principle of asset allocation comes in. There is general agreement among personal financial advisers that asset allocation is one of the most important keys to successful investing for investors of all ages and degrees of tolerance for risk.

Asset allocation refers to the division of investment money among the various classes of investments, stocks, bonds, cash and cash equivalents, appropriate for individual investors.

Weigh timeline, tolerance

So, what is the best asset allocation for you? Should you have 10 percent of your portfolio in stocks, or should it be 80 percent or 90 percent, or something in between? What about the rest? Should you invest the balance in bonds, CDs or other cash equivalents?

That depends on several important variables. At the top of that list is your tolerance for risk. Next is your timeline. The longer you have before retirement, the larger should be the portion of your portfolio invested in stocks. That’s because historical averages show that stocks provide the best return of any class of investments over a long period.

Thus, if you have lots of years before you must start drawing down your investments, you have time to ride out the inevitable dips in the market that cause stocks to fall in price temporarily. In short, how you allocate your investments depends on your age and your personal tolerance for risk.

For people investing over the long-term (10 years or longer) some advisers suggest a balance of 60 percent stocks, 30 percent bonds, and 10 percent cash. For really long periods, say 40 years or more, as much as 80 percent or 90 percent in stocks might be appropriate.

Investors close to retirement may want to avoid the potential volatility of heavy investments in stocks by putting most of their portfolio in bonds and cash equivalents. For more information on asset allocation, log on to http://www.investopedia.com/articles/04/031704.asp. Additionally, many banks and brokerage firms have published guidelines for asset allocation in differing circumstances.

Ultimately, the choice is yours. No one knows your investment goals and your tolerance for risk as well as you do.