You worked hard to save for retirement, buy your first home, or buy that vintage 1999 Mazda Miata you've always wanted. While it’s important to contribute enough to eventually reach your goal, how you save for the goal is important too. Each financial tool has its own risks and rewards. With so many ways to build up a stash of cash, what is the best method for you? Today, as a continuation in my series on risk, we will identify risk in common components of personal finance.
I wish I knew that kid when I was young. He could have gotten to all the candy hidden on the top shelf!
What Are My Options?
Before determining the appropriate amount of risk you should take, let’s explore our options for where we can save and invest our money. You can, of course, keep physical money somewhere safe… like a safe? This would be the most conservative approach – you know the money is there, but it will accrue no interest, dividend or capital gain while sitting around. If you don’t feel like holding the money yourself, you could deposit the money in a checking or savings account. The money is typically insured (in the U.S., FDIC insurance protects your money up to $250,000) and may bear some interest. With interest rates near historical lows, you won’t realize much gain. Be careful, though – look for no-fee accounts so you don’t lose money! If you’re seeking for better returns, and know you won’t need the money for a while, you could look at Certificates of Deposit, or CD’s. A CD is a financial instrument where you put in a fixed amount of money and, after a set period of time, receive that amount of money back with interest. While you will likely get better returns from a CD than a checking or savings account, your money is tied up; you can withdraw, but will face substantial penalties erasing your gains if you do so. Treasuries, or T-Bills are another method of gaining slightly better returns than your bank account. With a T-Bill, you’re essentially buying government debt at a slight discount. For example, you may buy a 10-year note today for $90, where it’s worth $100 at maturity (10 years from now). You would essentially get $10 of interest over 10 years for your $90 investment. Big money! While the windfalls of these types of investments may not thrill you, they are incredibly safe.
If these layups don't float your boat, you could dunk on fools with equity investments. The most common would be stocks, where you’re buying a tiny fraction of a publicly-traded company. The stock market returns about 7% annually on average, but presents a good amount of risk. While market trends may drive stocks higher or lower as a group, individual stocks can act independently, so there’s no certainty around your potential gains. Of course, with any equity investment, you can also lose money. If you're looking to mitigate risk with stocks, ETF's or mutual funds are a good way to diversify and mitigate risk. Other options for equity investing could be buying into a business, collectibles, real estate, etc. With any of these options, your potential risks and rewards are much higher and much less predictable.
Risk, Reward and Liquidity
With personal finance, we often think about risk in terms of reward. For example, you may buy a tech stock over a consumer staples stock thinking that the higher risk is outweighed by the potential payoff. However, one consideration that gets overlooked is liquidity. In terms of an asset, liquidity is how easily you can sell or exchange it for another asset. Cash, or cash holdings, would be the most liquid. You can exchange cash for pretty much anything (legally speaking, of course!), and you have access to it immediately. Other assets like T-Bills, stocks, or similar holdings are less liquid, but there is enough demand that you likely can sell them at market price without much issue. Side note – there is a major difference between post-tax investments and pre-tax (a 401(k), for example). While you can access post-tax investments relatively easily, pre-tax may require incurring a penalty on top of standard taxes. Along these lines, a CD is illiquid until the maturity date unless you’re willing to accept the penalties. For all these investments, it may be a matter of days or a week between selling the asset and having cash on hand.
But let’s switch gears to the other end of the spectrum. Assets like real estate, collectibles, and owning (in whole or partially) a business can be difficult to sell. Of course, this is certainly a case-by-case basis, but worth considering when investing in an asset. The market for these assets follow supply and demand. If you know me, you’ll know where I’m going with this scenario. Beanie Babies! The market for sacks of beans was rocking in the late 90’s, but dried up soon thereafter. If you “invested” in these, and didn’t capitalize on the peak of the craze, you may still have them in your basement storage. This is not to say you couldn’t sell them at a garage sale for pennies on the dollar, but compared to what you may have spent, they have depreciated tremendously. For more, shall we say, timeless assets like real estate or businesses, there certainly could be demand to buy, but again subject to market conditions. If you own a $35 million home next door to a chemical processing plant, you will struggle to find a buyer anywhere near this price. However, if you have a reasonably-priced home in a seller’s market, you’re likely to find a buyer easily. For a business, it’s hoping to find a good buyer who can give you the right offer – but it all depends on how desirable the business is. If you’re trying to sell your 27 franchised internet cafes, it may be difficult to find a buyer interested in a mostly-ubiquitous technology alternative business. No offense if you’re currently reading this at an internet café!
If you take anything away from this week's discussion on risk, it's that there is no right or wrong in taking financial risks. It's really all about what aligns with your life. You also need to know the risks, rewards and liquidity of any investment before diving in, and strive to make a balance. Finally, understand that Beanie Babies will always have a warm, cuddly place on Dough-Nuts. Have a good one!
Comments