Thursday, June 21, 2012

Why Do I Need A Big Pile Of Money?


The objective of investing is not to make a “big pile of money.” Or is it? This is not a real goal – it is a fairy tale. We think we’d love to make a “fortune.” But how much is a big pile, a lot, or even a boatload? How much is enough? What do we need it for? What are we trying to accomplish?

There are many ways to invest and looking at the relationship between risk and return is essential. Small risk equals small return. An example: money market funds that currently yield about one tenth of one percent per year would return $10 per year for every $10,000 of investment. Not very exciting. 

On the other hand, if you are willing to take more risk, you may expect greater returns. Those who bought stock in the recent Facebook IPO did so with the expectation of being richly rewarded . . . at some point in the future.

The riskier the investment, the wider the spectrum of possible results becomes. The timeframe within which you need the money is a key factor. Can you afford to wait through some short-term or even longer-term ups and downs?

Lessons From the Lottery
When you go to the corner store to buy that lottery ticket, you are gambling (not investing) on a chance of hitting the jackpot. Most often you don’t win. You make a conscious choice to risk losing all the money you paid for tickets, on the slim chance of beating the overwhelming odds. You may be shocked to learn that some 80 percent of lottery winners declare bankruptcy within five years! Maybe winning that big pile of money isn’t so great after all.  

How Much Risk Can You Afford?
The goal of making a lot of money encourages risk-taking. The investments required to achieve the highest returns are usually the riskiest. Taking this kind of risk may not be what you want or need. Hopefully you know yourself well enough to determine how much risk you are willing to take, but do you know how much risk you can actually afford?

Determining the risk we can afford depends on having a clear notion of the goal or objective of our investments. Instead of simply aiming for the juiciest or greatest returns, we need to tailor our risk to a specific goal. For instance, if you are close to your retirement savings goal, you do not need to risk reaching for a big return. If you are not close to reaching your savings goal, taking more risk may be appropriate, but it should not be your only strategy. 

What is the Goal of Investing?
The goal of investing should be to earn a return commensurate with the risk that you can tolerate and afford. Preserving precious capital, investing for growth and managing risk are part of the process. Investing starts with your preferences, goals and values. The vague goal of making a lot of money fails to take into account much of your personal situation. It doesn't encourage a discussion of risk and return, need vs. wants or what it is you are really trying to achieve. 

Most people would be happier making steady progress toward their vision of retirement, rather than taking much greater risks and potentially falling short. While a big pile of money might be desirable, as an investment goal, it is not the answer.

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