Is a spin of the roulette wheel the same as investing in the stock market? What about the blackjack table? Should you go to Las Vegas and play a few hands of poker, or should you find a stock whose value you hope will grow? What’s the difference between using your money for gambling, and using it to play the stock market?
The short answer is: plenty.
For one thing, the longer you sit at the casino tables, the more the odds increase that you’ll lose. The longer you stay invested in a diversified portfolio, the better you are likely to do in the stock market, as your odds to succeed increase quite a bit. In other words, even though there is risk involved in both, the expected return at a casino is negative while the expected return in the stock market is positive.
But are you gambling with your future when you invest in the stock market? Or are you using the right tools to achieve a well-equipped retirement through successful stock market strategizing, by including market risk, asset allocation, and diversification when you make an investment?
Stock Market Risk
Analyzing the best stocks for your portfolio can be a bit of a gamble, yes, which is why examining risk and finding the best risk management strategies for you are both important. Buying individual stocks in an attempt to make a quick buck is a risky proposition. Assessing stock market risk is vital to any form of successful investing.
The stock market always inherently has some risk, based on the economy – from the possibility of recession or inflation to economic growth. To manage this predictable risk, you can:
- Build a diversified portfolio
- Don’t take more risk than you can afford
- Stick with a rebalancing plan (buy low and sell high)
- Develop an Investment Policy Statement and stick to it!
Asset allocation is one of the most important elements in building a successful investment portfolio. It means that your portfolio should allocate space for a variety of different kinds of assets: cash, stocks, and bonds or other types of investments, such as real estate.
You should consider the time you have to invest as well – if you have a longer time to save for your retirement, you might be able to take additional risks that potentially offer a large reward. Those with a shorter investment timeline – impending retirement is a perfect example – may be more comfortable with stable, less risky investments.
It is important to understand that possibly losing money in exchange for the potential of a larger return on your investment, also known as risk tolerance, is key to any investment strategy. Equally important is deciding how much you wish to achieve through your investment earnings. Both play a part in your asset allocation. After all, the amount of risk you take and the amount of gain you expect to achieve are correlated.
Many people choose to diversify when they consider asset allocation. They will invest in some asset classes with higher risk such as stocks and others with considerably lower risk, such as bonds and cash. Your investment choice is up to you, based on:
- The amount of time you have to invest
- The amount of risk you’re most comfortable with
- The type of investment you are most comfortable with based on these considerations
While stocks have the highest risk, they also offer the highest expected return. Bonds are steadier investments with less volatility, but they provide less return. Cash equivalent investments, from treasury securities to a money market account are the safest but have a significantly lower rate of return on your investment and may not keep up with inflation. Within the stock universe, you can further diversify your portfolio between large and small, growth and value, etc.
Allocating your assets across different types of investments with different types of risk is important to protect you against losses and lower your overall volatility. Plus, coming up with a game plan will help making investing less risky and a lot less like gambling in Las Vegas.
The element of gambling that comes into play with any investment portfolio is based on risk. To successfully invest, you must include enough risk to allow the most possible growth; at the same time, you can’t include an overly excessive amount of risk, or you may find money unavailable when you need it. To meet your financial goals, whether short term or long term, it’s all about balance.
Good asset diversification is a real-world example of the old adage that you shouldn’t put all of your eggs in one basket.
When it comes to your retirement planning, you want to build a financial safety net or cushion to fund a comfortable lifestyle even when you stop working.
Start by planning your goals for retirement, how much money you will need, how much you want to have, and the risk that you’re willing to take with the investments. You will also want to consider just how long a time you have to make this investment in your future.
Yes, you must save money to invest it, but you have to do more with that money than merely save it in your sock drawer to make your money grow for retirement. Remember, your plan for retirement should focus on how long you have until it’s time to retire, your risk tolerance, and return on your investments after taxes. And don’t forget about estate planning – that’s important too.
In general, a longer timeline until retirement means you can take on more risk because you don’t need the money for a longer period of time. As you approach retirement age, you may wish to shift gears to a more conservative investment approach.
However you choose to invest, whether it is for a retirement far in the future or just around the corner, there is always an element of risk. The way you win long-term is to build a balanced and diversified portfolio.
Written by Eric Keating