How Much Risk Should you take to achieve your Financial Planning Goals?
During the Financial Planning Process, you need to discuss risk in relation to your different goals with your Financial Planner. The goals you set will require some level of funding and some rate of return on your investments, and your expected return and the amount of risk you are going to assume will be related.
The higher the return you need, the higher the risk you must ordinarily take. It is a basic principle of finance that the higher the expected return on an investment, the higher the risk associated with it. A United States Treasury Bill (T-Bill), which is a short-term debt instrument backed by the full faith and credit of the U.S. Government (and its printing presses) is considered a risk-free investment. The government can and does print money to pay you back, and it always has, so despite the credit downgrade in 2011, it is considered to be the only risk-free investment.
Risk-free in this instance means there is no risk in getting back the money you have invested, plus the interest or return on your investment that you were guaranteed by the borrower (the borrower in this instance being the U.S. Treasury). Of course, if the government decides to print too much money, it might lead to inflation, which will erode the value of your investment. So even this risk-free investment has some risk…no wonder people have a hard time with financial planning and investments!
Every other investment has a higher element of risk. There is a wide spectrum of differing types of investments. The basic investments available to most people would be arranged by risk/reward in the following order from the least amount of risk to the most: T-Bills, Money Market Funds, Short-Term Bonds, Intermediate Bonds, Long-Term Bonds, High-Yield Bonds, Foreign Bonds, U.S. Large Company Stocks, U.S. Small Company Stocks, International Large Company Stocks, International Small Company Stocks, and Emerging Market Stocks.
Ideally, you should own some of these different types of investments in a way that provides the return necessary to achieve your goals while minimizing your risk. Any extra risk is unnecessary and actually counterproductive. You might have less of a chance of meeting your goals if you take on too much risk.
This is a point that most people don’t seem to understand. They divorce risk from the risk/reward relationship. They look at expected returns from different asset classes and decide they want the one with the largest expected return, not appreciating the level of risk they have exposed themselves to. Sure, international small cap stocks or promising young technology companies sometimes pay off handsomely, but sometimes they go broke. It doesn’t make any sense to take on more risk than is necessary. The markets really are risky. People get hurt.