If you need to send money into the future to pay for anticipated expenses, you may need to become an investor. Thinking carefully about your desired lifestyle is the first step in deciding (1) how much money you and your family will need to fund your future standard of living; and (2) how much risk you need to take with your investment program. If you need to earn more than the risk-free rate available in a CD or US Treasury security, then you need to take some risk—there is no free lunch. Once you determine that you need to be an investor, the process begins with asking: “How much return do I need to earn?”
Unfortunately, investors sometimes begin with the question: “I have some money and I want to accomplish ‘X’ [‘X’ can be any goal or set of goals]; what should I buy?” Prudent investing rarely begins with asking what you should buy. Worse yet, some investors buy whatever looks good at the moment—“I’ll buy this because it has a great track record;” “I’ll buy that because it offers a high return;” I’ll buy some other thing because it looks “safe,” “low-risk,” “well-balanced,” “conservative,” “aggressive,” “all-weather,” or, perhaps the worst of all possibilities, because it is a “once-in-a-lifetime-opportunity.”
Most people agree that more money is better than less. However, there is a trap for unwary investors. Here is the way the trap works:
- The goal of investing is to earn money;
- The more money earned, the greater the success of my investment strategy;
- The faster money is earned, the more financial security for myself and my family because a surplus of money will cushion future investment risks;
- Therefore, what investment can I buy now that offers an opportunity to make profits quickly?
The investor falls into this trap whenever he or she fails to distinguish between desired return (what return do I want) and required return (what return do I need). High returns are, of course, always desirable. However, strategies designed to maximize return may be inappropriate if they ignore risk. The prudent investor seeks to build a portfolio offering a high probability of successfully meeting future needs. Although this might sound like a treasure hunt for high-return investments, it is, in reality, a very different concept, and requires a very different approach to investing and wealth management.
Return and risk are related; and, therefore any decision concerning return is also a decision concerning risk. Even a “safe” investment can be risky if it is unlikely to produce the required return. This risk is known as “shortfall risk.”
Bottom Line: Don’t fall into the investment trap. It is folly to invest without understanding the return required for successful funding of your future objectives. In a nutshell, expected investment return must align with the return you need at a risk level that allows for a good night’s sleep.