Understanding Risk and Basic Investment Concepts

When you’re a young adult (age 22-30) just starting your career, you’re facing a number of decisions for perhaps the first time in your life—where to live, whether to rent or buy a house, finding a job that suits your skills, how to get the grocery shopping done, and paying for all of the bills that you come with your newfound independence.

One thing that you might not be thinking about at such an early age is investing.  Yes, you know that one day you’ll want to retire, but that day is far into the future.  At the moment, there may seem to be bigger things to worry about, and more important things to do with your money.  However, there are small steps you can take now that will provide big payoffs down the road.

Understanding some basic investment concepts is the first place to start.  In addition, being knowledgeable about risk tolerance and time horizons will help you to be able to make informed decisions. 

Basic Investment Concepts

When you’re starting out on your own, it’s important to stop and evaluate yourself to determine what type of investor you might be.  Some people are naturally risk-averse, while others are comfortable with risk.  Some people like to be more active in their investment management, while others prefer a more passive approach.  Regardless of where you fall on the risk scale or your preferred method of investing, you need to understand what to expect with different investment approaches.

Risk and Return 

All investments contain risk.  Whether you’re buying a stock, bond, or other investment vehicle, there’s no guarantee that you will make money, and there’s always a chance that you could lose some of (or all of) your investment.  When assessing whether something might be a sound investment, it’s important to understand the correlation between risk and return.

Everyone would like an investment that involves no risk and offers the potential for a high reward, but that’s not the way that things work.  In general, there is a tradeoff between risk and return.  The greater the risk, the greater the return you should expect if the investment works out.  On the flip side, the less risk taken, the less return you should expect.  If you hear about a scheme that promises great returns with no risk, it’s just that—a scheme.  Be aware that if you want the chance of higher returns, you have to be willing to take on more risk.

Classic Investment Strategies

When you begin to invest in the stock market, it’s important to understand some different investment strategies.  Passive investing is a style that usually involves investing in a mutual fund or exchange-traded fund (ETF) that seeks to mirror a market index.  For instance, if you want your investment returns to be a close match to those of the S&P 500 Index (“S&P 500”), you can buy an ETF whose underlying holdings mirror the weightings of the index, and therefore its returns will mimic those of the index.  Active investing attempts to outperform the market (or is agnostic to what the market is doing) through its selection of stocks.  Active investing may outperform the market at times, but it also may underperform the market at times.  Someone who would prefer to not pay as much attention to the stock market might prefer passive investing, while someone who takes a greater interest in stocks might be drawn to active investing.

In addition to deciding between active investing or passive investing, there are other factors to consider.  Value investing involves picking stocks that appear to be trading for less than their intrinsic or book value.  You can think of it as looking for stocks that you think the stock market is underestimating, with the idea of buying stocks in quality companies and having a longer-term time horizon.  Growth investing looks for companies whose earnings are expected to increase at a greater rate than the overall market (or more than similar companies).  With growth investing, the idea is that those companies that are growing earnings at a greater rate are also going to see their stock prices go up commensurately.  Value investors tend to be more conservative, while growth investors are often seen as those willing to take on more risk. 

 

Risk Tolerance and Time Horizon

There’s a general rule that the longer your time horizon, the more risk you can assume because you have more time to recover from your loss.  If you’re 25 years old and only focused on retirement at age 65, being fully invested in stocks makes sense.  If the stock market is down 15% in one year, there is still plenty of time for your money to grow.

If you invest $1,000 at age 25 and are counting on an average annual return of 9% until retirement at age 65, even if your investment drops by 15% the first year, you still have 39 years to make it up.  An average annual return of 9.7% over the next 39 years still gets you to your goal.  But if your time horizon is only 5 years, that 15% drop in the first year means that you have to have an average annual return of 16.0% for the next four years to get to where you want to be.

As you progress through life, you’ll find that you have short-term, intermediate-term, and long-term time horizons.  When you’re in your 20s, retirement is a long-term time horizon, so you can take on more risk.  But if you’re looking to buy a car in the next year, you’ll want to have the money earmarked for that car much more safely invested.  Risk tolerance in one area doesn’t necessarily carry over to other areas, no matter what your age. 

How to Get Started

When you’re a young adult facing a lifetime of financial decisions ahead of you, it’s important to start strong.  By working with a professional financial adviser, they can help keep track of your financial situation and give you clear, objective advice to ensure that your financial goals are met.  Find someone that you’re comfortable with and let them help guide you on your financial journey and avoid some of the common pitfalls out there. 

About Chase Investment Counsel

Chase Investment Counsel is a family and employee-owned boutique wealth management firm that offers personalized investment services. Our clients include career professionals, those nearing or in retirement, and families experiencing financial transitions such as generational wealth transfer, widowhood, divorce, or sale of a business. Chase’s active, disciplined investment management team is focused on selecting individual stocks and bonds targeted to each investor’s specific financial goals and risk tolerance. Established in 1957 in Charlottesville, VA, Chase Investment Counsel manages more than $300 million in assets.