Understanding Risk and Reward

What has drawn you to investing? Maybe it’s the raging stock
market of the 1990s. Or maybe you’re enticed by the idea that
you can put your money to work for you by investing it.
Although the benefits of investing are often made clear in
success story after success story in advertisements, magazines,
newspapers, and online Web sites devoted to investing, it’s
important to remember that there is no gain without potential
pain. That means that when you invest your money, you
can lose part or all of it.

Actually, rewards and risks are usually closely related. The
greater an investment’s potential for reward, the greater the
potential for risk and actual loss. The high-flying stock that
earned a 100% return last month is probably the very same
stock that will tumble (and tumble hard) in the months and
years ahead. The same goes for bonds and mutual funds and,
potentially, even real estate.

You must take on some risk in order to reap the benefits of
investing. That’s the bad news. The good news is that sometimes,
over time, a decent investment may bounce back and
make investors whole again.

What’s the best I can hope for?

The best you can hope to achieve with an investment
depends on the nature of the investment. Some investments
— such as savings accounts and certificates of
deposit (CDs) — offer stable, secure returns. Other — such as stocks, bonds, and mutual funds — depend
entirely on market conditions. A return is an investment’s
performance over time. It’s easy to calculate the best-case scenario
with vehicles such as savings accounts and CDs. On
the other hand, you can never predict with 100% accuracy
what kind of return you will get with more volatile investments
such as stocks, bonds, and mutual funds.

You can, however, see how these investments have performed
in the past. Recent history has many investors believing that
the markets can only go up. If you look at returns on some
stock investments, you can understand why.

For example, the top-performing stock in 1998, which was
an online Web site called Amazon.com, racked up staggering
returns of 966% in 1998. If you were lucky enough to
invest $1,000 at the end of 1997, your money would have
been worth $10,664 a year later. That’s probably the best oneyear
return any investor can ever hope for — and then some.

The next-best-performing 24 stocks in 1998 returned
between 164% and 896%. The best-performing stock
mutual funds returned well over 70%. In sharp contrast, the
best corporate bonds returned more than 15%. Still, if the
average stock returns about 10% a year, 1998 was quite a year
for many investors.

In fact, the year capped off a
decade-long boom for the stock
market in which the top-performing stock (Dell Computer
Corp.), over the ten-year period from 1988 to 1999, gave
investors a very pleasing 79% average annual return. Equally
noteworthy, the next best 24 top-performing stocks returned
43% to 69% in the same period.

On average, however, stocks, bonds, and mutual funds don’t
give investors these kinds of returns. Large company stocks
returned only about 18% during the past decade. Corporate
bonds gave investors about 10.8% in the same period.
What’s the worst-case scenario?

You’ve heard about the best you can hope for, now what
about the worst? The worst performer in 1998 cost investors
a frightening 83%. In other words, $1,000 would have been
worth just $170 by the end of the year.

You can lose all of your money in an investment if a company
declares bankruptcy.

What’s a realistic course?

The good news is that if you try to choose your investments
carefully — and subsequent chapters of this book give you
the tools to do this — you should be able to minimize your
losses. Ideally, your losses from any one investment may even
be offset by the successes of your other investments.
Chapter 1: Setting Realistic Goals and Expectations 7
The emphasis should be on choosing investments carefully,
which means that your expectations need to be realistic, too.
Stocks have returned an average annual return of about 10%
since the 1930s, so aiming for a 15% or 20% return is unrealistic.
Corporate bonds returned about 6% in the same time
period, so a 12% long-term average annual return from
bonds isn’t realistic.

Of course, if you’re completely uncomfortable with the
prospect of losing money, or if you need your money before
five years, then investment vehicles such as stocks and bonds
aren’t for you. You’re better off putting your money into safer,
more liquid places such as bank accounts, certificates of
deposits, and money market accounts, which I talk about in
Chapter 2.