Defining Profits in Investing
In examining how people define profits and risks in investing, let’s begin with profits – the more exciting side of the equation. When investors evaluate their profits they often overlook or regrettably forget some of these most important facts about profits:
1. Profits are not profits until the gains are realized. You may think that you have profits as you watch your investments in your portfolio increase in value every day. But these are only unrealized gains and until you sell you have not made a profit. “Paper profits” exist, but real profits are more like gold – something you can physically touch.
2. Profits need to be reinvested to remain profitable. Even after you sell your security and have realized your profit, now what? You have the equivalent of cash sitting in a money market account earning almost nothing these days. While hoarding cash makes sense as an investment strategy during times of deflation, currency readjustments and inflation can slowly and quietly reduce the purchasing power of your profits.
3. Profits are more than buying low and selling high. In assessing profits in a security, investors must factor in not only the capital gain realized but also dividends or other income distributions paid while the investment is held. Some securities are more profitable over the longer run. For example, one of the most profitable investments has been stocks with a long history of consistently increasing their dividends payouts.
4. Greed is a component for higher profits. To reap higher profits, the investor has to have a certain amount of greed. But what is considered too greedy? Taking profits is essential in investing, but many investors fail to take profits because of greed. Defining profits in terms of stock market index benchmarks is one way to control this emotional component of investing.
Defining Risks in Investing
Risk in investing is the culmination of the fear and uncertainty that a particular investment will not yield a satisfactory return or even worse that the investor will lose the initial capital invested. What is important for investors to keep in mind is that risks come from multiple directions that may or may not relate to the fundamentals of the particular investment. Also, risk is a relative term because individuals have different assessments of risk depending upon their risk aversion and time horizons. As with profits, there are some general principals that investors should know in order better manage their risks in investing.
1. Asset allocation can decrease risk. Diversification in stocks, bonds, commodities, currencies, etc., reduces risk to the investor’s total investment portfolio because asset classes usually respond differently to external drivers in the market. However, lately there has been an increasing tendency for investment classes to move together, which adds a market-driven risk in addition to the fundamental risk inherent in the underlying security.
2. A longer time horizon can decrease an investor’s risk. Markets go up and down and they can also melt up or crash. As long as an investor’s time horizon is not tomorrow or even next year, the risk of investing is smoothed out over a longer time horizon. Historically the S&P has averaged an annual return of 8 percent. However, because of the recent burst of the housing bubble 12 years of S&P gains have been wiped out. The lesson learned is that asset bubbles create additional risk that investors have to be aware of.
3. Short term speculators create additional risk in the market. A sound piece of investment advice is to avoid the crowded trade being propelled by pure speculation. While playing a momentum trade can be very profitable, running with the short term speculator bulls is one of riskiest strategies.
4. Economic risks. There are a number of risks associated with investing that are not directly related to the underlying strength or weakness of the security or the dynamics within the marketplace. Economic conditions such as high cyclical unemployment and rising sovereign debt are playing an ever increasingly role in mounting new risks in investing.
Correlation Between Profits and Risks in Investing
There is a strong and direct relationship between profits and risks, and investors need to understand that the relationship is both positively and negatively correlated. The higher the risk, whether it is fundamental, market-driven, or economic can lead to higher “potential profits” but also devastating losses.
References and Image Credits
“Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing.” U.S. Securities and Exchange Commission (Home Page). https://www.sec.gov/investor/pubs/assetallocation.htm (accessed September 18, 2010)
Gold coins: Graur Razvan Ionut / freedigitalphotos.net
Banana under foot: Chris Sharp / freedigitalphotos/net