You take risks in your life all the time. You get in a car even though you might have an accident, and you play hockey even though you might fall on the ice. But because you're smart, you minimize your risks. You wear a seatbelt, and you wear a helmet.
Other risks are more subtle, and harder to manage. Sometimes I hear from investors that they don't want to invest because they feel it's too risky. The last week has been no exception. It’s been a really volatile week in the markets and we know it feels like things are beyond your control. And while that’s true in some areas, in others you can make a real difference. Of course there are some risks, just as there are when you are driving. But let's face it, if you're going to retire and meet your goals, you're going to probably need to invest your savings.
Why? It's the only way to earn the returns you need. It would be great if we lived in a world where you could make 20% interest on your bank cash deposits. But you can't. Most banks are paying much less than 1%, and that kind of return probably isn’t going to cut it for your plans.
Smart investors learn how to minimize the risk so that they get the returns they need and feel comfortable with what they're doing.
How? The first step is identifying the risk, and the second step is figuring out how to minimize it. By the way, I'm talking about "risk" the way most people think of it, which is the risk that your investment will fall in value and/or the risk that you won't meet your goals. Investment professionals have a technical definition of risk, which means volatility. For a definition, read the five most misunderstood words in investing. It's related to the second risk on my list.
Here are the three biggest risks that keep people from investing, hurt their returns or keep them from sleeping at night.
Risk No. 1: You'll pay way too much in fees
You probably suspect this is happening, but you're not really sure how or why. Typical financial services firms haven’t always been completely transparent about how much money they charge. By the way, my commitment to you, as CEO of Nest Wealth, is that we will always be transparent about our fees. No surprises here.
You're smart to worry about this risk. Whenever you invest, you could be paying high and hidden fees that can shrink your portfolio by hundreds of thousands of dollars. That's what happens to many Canadian investors who put their money into mutual funds, not recognizing that they will pay an average 2.5% annually. On a $200,000 investment over 20 years, saving 1% in annual fees could make a $161,000 difference.
There are three ways to minimize the risk you'll get taken to the cleaners.
• Do the research yourself. Do the research yourself by reading the disclosures on your investments or scouring sites like Morningstar Inc.
• Ask very pointed questions about the fees. Ask "How much am I paying, all-in, for this investment, to buy it, to keep it, and to sell it when I do?" The key is not to ask how much the financial services company is charging, but to ask how much you're paying. In any financial transaction, there is a chain of companies involved (usually, at least, a provider of the investment and a seller of the investment) and each one will typically be charging its own fee. So if you ask one company, its representative may not tell you about the charges from the other companies in the chain.
• Find a super-transparent advisor. Or find an investment advisor committed to helping you understand how much you're paying. I'm proud to say Nest Wealth is that type of advisor.
Risk No. 2: Timing or trading risk
This is the risk that you will trade at the wrong time, usually because your fear or overconfidence gets the better of you. If you think you're not prone to doing this, think again. While the S&P returned 11% in the 30 years ending in 2014, the average U.S. stock investor only earned 3.7%. Why? When the market falls, people tend to sell, and they almost always sell at the wrong time. This risk also affects people by keeping them from investing at all: they think if they wait for the right moment to get it, they'll make more money. But again, people tend to get this wrong.
How to minimize the risk:
• Get started: Don't stay frozen just because you're not sure you understand the right timing to start investing. Nobody can predict the future, except that history tells us that over time, the market rises. Don't miss out on it.
• Don't panic. So long as you don't need the cash in the short term, stick with your investment plan.
Risk No. 3: You'll need your money at a market downturn
In technical terms, volatility is the amount that an investment can vary from its expected returns, which are based on how it's performed in the past. An investment with a lot of volatility, like an emerging markets index fund, is more likely to have big swings in annual return and value. Any investment has some volatility. The market as a whole has volatility. But the most important volatility for you is the one your individual portfolio has. If you looked at all the investments you hold, what would your portfolio’s volatility be? Understanding volatility can help you minimize the risk you'll be caught in a downturn just when you need your money.
How to minimize the risk:
• Diversify your portfolio. You can lower the actual volatility of your portfolio by being careful about what you put in it. Invest in several asset classes at once (David Swensen, the chief investment officer of Yale University, suggests six). At Nest Wealth, we use the latest investing science to match the diversification of your portfolio with your particular circumstances, including when you'll need the money and how comfortable you are emotionally with volatility. Any advisor who doesn't ask you when you need the money so that you can have a personalized portfolio isn't doing their job.
• Rely on time. Young investors don't need to worry as much about needing their money at a downswing; they can afford to wait it out. People with cash on hand and a healthy income, say enough to meet your needs for a reasonable amount of time, also have less to worry about when it comes to short term volatility.
For one more piece of advice, visit the Nest Wealth Blog.