Risk vs reward

Everyone wants to invest their money and make a lot back without any risk. Unfortunately there are no can't miss high yield investment opportunities because as soon as they are discovered, other investors ("the market") jump in and take away that competitive advantage.

Sure, there are high yield investments out there, but they come with their risks - and the higher the return potential = the higher the risk potential. Every investment out there comes with some risk, the lower the rate of return the lower the risk.

Examples of low risk investment opportunities:
- Savings account at 1% - no risk at all since your bank is FDIC insured up to $100,000 of deposit. That means that if the bank goes under you get your money back.
- CDs at 2%-5% - no risk either (also FDIC insured), but there is the inconvenience of having your money tied up for a period of time (depending on the CD terms).

Examples of high risk investment opportunities:
- Investing in the Stock Market - high risk, chance to lose every dollar you put in.
- Investing in the Options/Futures market - very high risk, need a PHD to understand, but can yield great returns.

Examples of medium risk investment opportunities:
- Real estate - the returns can be high, but usually you have to wait a very long time to recognize them. Real estate (at least your primary residence) should be viewed as a necessity, not an investment.
- College - again, the returns can be high, but it is a huge time and effort investment. Also, the higher the college price the higher the level of education (usually) which means the higher the returns later in life.

The point of this message is to access how much risk you can handle in your investment portfolio and then invest accordingly. Generally, if you are younger you should invest in higher risk investments because you can afford to lose more, because you have many years before retirement to earn back or save up the money. The older you are the less risk you should take because you can't afford to lose the money you are setting aside for retirement because you have less years to earn it back or you are on a fixed income. Fixed income is generally the interest you earn on your investments and social security. Social security is not guaranteed, so no one should rely solely on that as a source of income.

One way to reduce risk is to "diversify" your portfolio. Your portfolio is all your investments in total. If you put all of your money into one type of investment or market, you run the risk of that market going up, or worse, going down. For instance, putting all of your money in the stock market is a good idea - putting it all in one stock is not such a good idea. Your entire return will depend on only that stock - if that stock crashes you will lose everything. The same can be said for one type of industry, like oil and gas, or something tangible like real estate.

The best way to diversify your risk is to spread your investments around. Your home is a great investment because even if the market tanks, you will still need a place to live. In the stock market there is mutual funds and index funds that are made up of pieces on many stocks. This way if one stock goes down it is only a small portion of the total investment. Some mutual funds are built for steady returns, and some are built for fast returns - each will have the proper return associated with it.

Then of course, you should have some of your investments in bonds and CDs - these are liquid assets that have steady controlled returns with little risk. These are designed for people who are risk adverse but still want to make something on their money. You should consult an investment advisor if you have any questions on any of the investment vehicles out there on the market.

The other thing you need to do is create a plan for the future. What do you want to do in retirement? Do you want to live on the beach? Live on a golf course? Live with family? Travel the world? Estimating your living expenses when you retire is a difficult step, but one we all need to do.

Let's say you are 40 years old and have 25 years until retirement. You'd like to live in FL in a retirement community and travel a couple of times a year. Well, your living expenses will include monthly rent, groceries, phone, supplemental medical insurance, car insurance and extra cash.

Let's say all that costs $2,500 a month in 2007 dollars. Anticipating a 1.5% inflation rate for every year until you are 65 would add 37.5% to that total. So, a $1 today = $1.37 in 2032. Thus, it would probably cost more than $3,400 a month to live in 2032. $3,400 X 12 months is over $40,000 a year. Plus, you probably want $10,000 a year for travelling and other expenses. Assuming you live to be 80, that's 15 years X $50,000 = $750,000 needed to retire.

That seems like a lot, but if you break it down over the 25 years you have left until retirement, you would have to save or invest $9,500 a year (at an 8% interest rate). That may seem like a lot today, but if you think about it, you spend a large portion of your income on a huge investment - your home! All the equity you are building will help you later on when you sell your house and buy a smaller one, or sell it and retire to a condo/townhome on the beach in FL. It will also get easier to save money as you get older and after you have kids, they get through college, you travel less, you decrease your spending, etc. Its not impossible to save for the future.

So, before you think about dropping your hard earned dollars on the next sure investment that pays tons of cash - remember that if you aren't willing to lose every cent, you shouldn't invest it. But be sure you are investing something - the biggest mistake is missing out on planning for your future.