Have you ever been at an amusement park where they have a bridge, with a spinning drum surrounding the bridge? The drum has an optical illusion printed onto it and it is illuminated with a black light. You cannot see the actual bridge you are walking across, because it is pitch black, and the illusion of the spinning drum has you so disoriented that it is difficult to even walk. I have been on such a bridge, and let me tell you, it is a very insecure feeling. To say I inched my way across would be an understatement. I moved slowly along the bridge, gripping the railing firmly as I made my way across to the other side. Even though I knew what was going on, and I could see the end of the tunnel twenty feet away, I was still uncomfortable and anxious to get out of the tunnel.
The stock market can be a similar experience. Like they were navigating a twirling tunnel, many people can be left feeling disoriented and confused about their investments. After all, no one can predict the future of the stock market, and there is no guarantee against loss. Simply put, inherent in the stock market is the risk of losing money! So it is understandable that people have some level of uncertainty about their portfolio. The key to overcoming some of the anxiety associated with investing is managing risks and preventing them from paralyzing your decision-making process.
There is some level of risk associated with nearly everything we do. Driving, for instance, carries risk. You could hit someone with your vehicle, or someone could hit you, causing damage to both vehicles. So what is our process for handling the financial risk of driving?
- We accept the risk that if we are in an auto accident and our car is totaled, we will buy a new car. We understand the odds are high for a safe arrival at our destination without the need to worry about an accident.
- We can manage the risk by driving defensively, with our hands on the steering wheel at ten and two, while keeping one foot on the brake. Staying highly alert while driving, without the radio or cell phone to distract us, perhaps lowers our risk of an accident.
- We can purchase auto insurance and pass the financial risk onto the insurance company. Most drivers cover their risk by purchasing insurance, which transfers the risk away from the driver and onto the insurance company. If we are in an accident, we make a call to our insurance agent, and the rest is on them to get the vehicle back to new.
- We could avoid the risk altogether and not drive. There is public transportation and other options for getting from one place to another, and thus we can avoid risk altogether.
So how do we apply this to investing? The fact is that investing in the stock market can make us money; otherwise we would not do it. However, just as with driving, there is financial risk when investing. We can lose money as a result of a market downturn. We can lose money from government actions. We can lose money from a news headline. There is risk all around the markets. So what is our process for handling the financial risk?
- We can simply accept the risk that if money is lost, we will move on and find another investment. The acceptance of risk goes hand in hand in terms of investing. You put your money into the market with the hope of outpacing inflation, and compounding your earnings for future use. Meanwhile, it is essential to understand that market conditions could diminish your anticipated investment. We can look at history and see that while history does not guarantees future results, it does provide insight into past performance and trends. That gives us the knowledge and understanding of what could happen as a result of making an investment. In other words, we can anticipate growth, but we really do not know what the actual outcome will be.
- We can manage the risk through asset allocation and diversification. There are investments that make money if an investment goes up, while there are other investments that make money if an investment goes down. At the same time, there are investments that historically perform well when another investment performs poorly. Having a mix of investments that cover many different markets can help to soften the ups and downs.
- We can insure our risk by passing it onto to an insurance company, just as we would the risk associated with our automobiles. Banks and insurance companies offer programs that allow you to pass the risk of a market loss onto them, for a fee of course.
- We can avoid the risk altogether and simply not invest. This approach eliminates market risk by avoiding the direct influence of the markets. By sticking with CDs or fixed annuity accounts, we avoid the risk inherent in the market. It is important to note that although we can avoid the market risks, we remain exposed to inflation risk. (Inflation risk is the potential erosion of earning potential over time).
As you can see, there are different ways to manage risk, and depending on your personality, your investment experience, your belief system about money and your phase of life, you will need to determine for yourself which approach make the most sense for you.
The most crucial step is that you must first identify why you are investing. We have already discussed—and will discuss again in other chapters—the importance of understanding the purpose for your money. I won’t be repetitive by explaining it more here, but I do want to reiterate how relevant it is to understand why you are doing what you are doing. If you fall into the trap of making a decision based on what sounds good, you run the risk of being sold a product without a full understanding of how it ties into your ultimate purpose for the investment.
While many people are accustomed to having data and sales literature as the driving force for their decision-making, your life phase (which we defined in an earlier chapter) should be your filter of what is or is not appropriate for you. In addition, your risk tolerance should guide you to reaching a level of comfort for how you manage your risk.
Here are some general guidelines to help you identify the level of risk you can tolerate, and how you may want to approach your decision about what type of investment to use.
- If you are a free spirit and believe that investments are more likely to go up than down, I would suggest a mix of growth investments with various capitalization. This is an aggressive, long-term approach to investing.
- If you are of the mindset that investments are the way to go, but you want to limit volatility across the portfolio, then I would look at a multi-asset class allocation.
- If you want to participate in market returns but do not want to risk losing money, I would suggest a market-linked CD, or an equity index annuity.
- If you are saving for retirement and are concerned about the possibility of losing money before you retire, or you fear running out of money once you are retired, an annuity may be a good option, since they offer income guarantees that often will last your lifetime.
- If you are scared of the market or simply do not understand it, stay out of it.
It is important to keep in mind when you are investing that picking an investment is not the same as financial planning. I have said it before, and I believe it is worth saying again—anyone can invest in the market. You can go online or to a neighborhood brokerage company to buy an investment, like you would buy a pair of shoes. It’s easy, convenient and can even be cheaper than working with an actual financial advisor. If you have the knowledge and confidence to do it on your own, I say go for it.
However, when it comes to distribution and the actual use of your money, it is not as simple and can actually be problematic if your portfolios and accounts are not arranged properly. That is often why I recommend using a professional, since he can help shine light on things that perhaps you are not thinking about.
The bottom line is that if you have questions about what investments to choose or are unsure of exactly what it means to distribute your money, then I highly recommend seeking out a competent financial advisor who has the experience and the ability to assist you in making smart choices. I have an entire chapter in this book dedicated to helping you find an advisor who is right for you.
Guarantees are based on the claims-paying ability of the Issuer and do not protect against market fluctuation. The guarantee only applies to the death benefit and does not cover the sub-account investments. Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values.