Investing: Risky business?
When some people think of investing, they focus on the potential for great rewards—the possibility of buying unknown stocks that increase in value many times over.
Other people focus on the risk—the possibility of losing everything in a market crash or on a bad stock pick.
Who's right? Well, it's true that all investing involves some risk. It's also true that investing is one of the best ways to increase the amount of money you have available to meet your goals (although an expectation of immediate riches is highly unrealistic).
In fact, there's typically a direct relationship between the amount of risk involved in an investment and the potential amount of money it could make.
Different types of investments fall all along this risk-reward spectrum. No matter what your goal is, you can find investments that could help you reach your goal without taking on unnecessary risk.
Time is on your side
Here's the secret ingredient that can make investments less risky: time.
Based on past history, if you invested in the stock market for 1 year, your chance of losing money would be greater than 1 in 4. But if you invested for 10 years, that number would drop to about 1 in 25—and after 20 years, to zero.*
Some caveats
If you invest in just a handful of stocks or in a bunch of stocks in the same industry, time won't necessarily make your portfolio any safer. Just ask someone who held Enron stock or e-commerce stocks for years, only to see their value vanish overnight.
The reason it works for diversified investment portfolios is that over time, there tend to be more "winners" than "losers." And the investments that gain money offset the ones that go bust.
Also, you have to leave your money invested the entire time. If you pull your money out when your balance has fallen and then start buying again when prices are back up, you'll just dig yourself into a hole.
The more time you have, the more you benefit from compounding
Not only can the passage of time help lower your investment risk, it can potentially increase the rewards of investing.
Imagine you place 1 checker on the corner of a checker board. Then you place 2 checkers on the next square and continue doubling the number of checkers on each following square.
If you've heard this brainteaser before, you know that by the time you get to the last square on the board—the 64th—your board will hold a total of 18,446,744,073,709,551,615 checkers.
No, we're not promising to double your money every year! But this principle—known as "compounding"—is important to understand: When your starting amount is higher, your increases are higher too. And over time, it can seriously add up.
As a rule of thumb, if your investments returned 6% annually, you would double your investment about every 12 years.
For example, if you earn 6% on a $10,000 investment, you'll make $600 in the first year. But then you start the second year with $10,600—during which your 6% returns net you $636.
In the 20th year of this hypothetical example, you'll earn more than $1,800—and your balance will have increased more than 200%.
Another caveat
If you take your earnings out of your account and spend them every year, your balance will never get any bigger—and neither will your annual earnings. So instead of making more than $20,000 over 20 years, you'd only collect your $600 every year for a total of $12,000.
If you instead leave your money alone, as you can see below, your "earnings on earnings" will eventually grow to be larger than the earnings on your original investment.
Leave your earnings invested and watch compounding go to work
This hypothetical illustration assumes a $10,000 investment and an annual 6% return. The illustration doesn't represent any particular investment, nor does it account for inflation.
What's next?
The best way to make these concepts work for you is to build a diversified portfolio with the right level of risk.
