I would like to know when taking a risk with your money became wrong.
I understand taking a risk with your money can be dangerous. It can be stressful. It is, of course, risky.
But when did it become wrong?
A few weeks ago I was commenting on Consumerism Commentary and Flexo wrote an article about selling some company stock he had earned when he was employed with some company in the past. The stock was much lower than it’s pre-recession high, but Flexo sold all of his shares and made a profit overall. I offered my opinion on the situation as follows:
If you don’t believe it is going to go up, then definitely sell. If you think it will rebound and you can make a nice profit, then hold. Looks like you are making the right decision based on how you feel about the company.
Seems like pretty sound logic to me. He wasn’t comfortable holding the stock, so he sold. If he had been comfortable holding the stock and thought it would go up, then he could hold and hope for a higher price.
Either decision is acceptable. Time will tell which was right and which was wrong, but since none of us know the future, both holding and selling are reasonable decisions.
That is, unless you believe Mr. Evolution of Wealth. Here are the first two sentences of his response to my comment:
Kevin:
No offense but that is pretty scary advice. You should make financial decisions on what you believe?…
Apparently my advice was not only bad; it was downright scary! You can read his whole comment here about why, according to him, it is absolutely wrong to invest a significant portion of your portfolio in company stock.
And if we aren’t supposed to make financial decisions on what we believe, then how should we make them? Maybe we should do it based on what Mr. Evolution of Wealth believes? I don’t think so!
His main point (and the point of most other commenters on that article) is that having too much money in one company is too risky. And risk is bad. Risk is very bad! RISK IS DANGEROUSLY BAD!
Bull Skittles! (that’s my PG version of B.S.) Risk isn’t inherently good or bad. It’s just risk. The more risk you are willing to assume, the higher your potential for gains and losses.
Diversification Minimizes Losses AND Gains
Financial gurus will tell you, “Diversify, diversify, diversify!” According to these gurus and Mr. Evolution of Wealth, a portfolio without diversification is stupid.
Well I’d like to ask all those smarty pants out there, which portfolio makes more money: a diversified portfolio with a 14% return or a risky, non-diversified portfolio with a 26% return? The correct answer is clearly and obviously the 26% return.
These people will dismiss it. They will call it blind luck. Worse, they’ll say it isn’t sustainable. They will try to make you believe over-exposure to any company will eventually destroy your wealth if it doesn’t do so instantly.
Tell that to people like my great grandmother who earned a few thousand dollars of Walgreens stock decades ago and held it until her death. It was worth millions when she passed.
Tell that to employees of Apple or Southwest Airlines or Walmart who have been at their companies for 30 years and have held their portfolio exclusively in company stock. Those people are probably swimming in money and laughing their butts off at their friends who heeded the “diversify!” advice.
There is also a flipside. Think of all the Enron employees that held their portfolio in company stock. They lost everything. That’s the negative risk you take when you don’t diversify.
If You Want Big Returns, Be Prepared for Big Losses
If you want all the potential for Apple-esque gains, you need to be prepared to accept Enron-esque results. That’s the magic of risk; it goes both ways. Would I hold 100% of my portfolio in company stock? No. But I am holding 50% of my 401k in company stock.
I understand the risks and I accept them.
I’m honestly prepared for 50% of my 401k to go all the way to $0. I doubt it will happen, but if it does, I’m young and will have plenty of opportunity to make that money back. Please don’t lecture me on it in the comments; I understand the risks.
I’m also prepared for the upside of risk. I’m prepared for 50% of my 401k to double or triple in the next few years. If that happens, won’t all those people with fully diversified portfolios be jealous?
I’m taking big risks with my money because I’m hoping for potential gains. Is it risky? Absolutely. Is it wrong? Only time will tell. But let’s get one thing straight:
A risky investment isn’t a bad investment.
Kevin McKee is an entrepreneur, IT guru, and personal finance leader. In addition to his writing, Kevin is the head of IT at Buildingstars, Co-Founder of Padmission, and organizer of Laravel STL. He is also the creator of www.contributetoopensource.com. When he’s not working, Kevin enjoys podcasting about movies and spending time with his wife and four children.
I think it’s ‘OK’ to take risks if you are fully prepared and OK with potentially losing the money. If you’re going to put $10k in what is defined as a ‘risky’ investment, you almost have to go in with the mindset that it could all be gone. Therefore, that can’t be earmarked for anything to do with paying bills or any spending that you know will be coming up. If the downside risk goes and you lose it all, as long as you can still pay the bills, do what you were doing before, it’s potentially worth taking. But, if you’re running the risk of this putting you in a tight spot, then it’s definitely not worth the risk.
That is solid advice. I’ve seen some really smart friends of do some extremely STUPID things because of a risk that turned south and put them in a tight spot they weren’t prepared to handle.
I am probably one of the most passive investors ever! I love reading these posts, but I’m just not in a spot to give investing this kind of energy. On the down side, my money isn’t growning quite like yours. On the upside, I have basically no risk!
At first, I thought “this Kevin guy is an idiot, picking stocks because you believe in them?”.
Then I read more, and now I think “this Kevin guy is a genius”.
Or at least you just have much more common sense than most people.
What this really boils down to is personal responsibility. If you want to invest in highly volatile stocks, do it, but you better not come crying to me (or the government) when you lose everything.
Bottom line is you had better be doing your homework. If you do, you will lessen your risk, but it will never be eliminated. Like you said… reduce risk… reduce returns. You gotta find your on comfort point.
In general, people who are interested in personal finance aren’t going to appreciate the idea of risk adjusted returns, or individual stockpicking.
Look at the number of articles out there in which people declare popular index funds to be a better investment than mutual funds that are actively managed. Yes, obviously a pure play in the S&P 500 will beat a 90% equities 10% bond portfolio without risk adjustment in a bull market. I think everyone knows that, but it doesn’t mean they have better risk adjusted returns, which is the only real way to measure investment performance.
I’m sure people would grill my portfolio to bits for most stocks being under $5. End of the day, though, they’re probably less risky than an index fund. Most of them I bought when they had anywhere from 30-50% of their market cap in cash on the balance sheet. That’s not risky; price of the security shouldn’t define risk. Great article.
No one can ever make a lot of money unless they take risky investments
Great tips and very interesting article. Thanks.
I don’t think you meant it this way (though maybe you did), but it sounds like from your comment you’re recommending people make investments based on a gut feeling, or a believe in some intangible thing. And that IS scary and terrible advice. People should make investments, or any decision in life, really, based on an understanding of the market, of what they’re investing in, of the way the company is likely to rise or fall, of how comparable stocks have done, etc. etc. It’s always a risk, and risks can be a great thing, but if you’re not making your big risk based on some sort of data, or at least an educated guess, then that’s just dumb.
Maybe that’s what Mr. Evolution of Wealth was responding to. It doesn’t sound like he was saying taking risks is a bad thing, even a big risk, but just cautioning against making foolish risks.
Hi Kevin I agree with you, a risky investment isn’t a bad investment, you just ned to know what you doing. be prepare and things can go in the right way.
I agree with your sentiment that many financial advisors inflate the value of risk avoidance. Risk should be managed. And taking large risk with large amounts of money that should not be risked is a very bad idea (even if you were to get lucky and do well). But avoiding risk is not always good. As you say, it reduces potential return. And when you can afford to take risks, avoiding risks can be very very costly (in lost opportunities for returns).
I don’t always agree with your view on things, but I do think you are right that a risky investment isn’t necessarily a bad investment.
That being said, I wonder if you really are prepared for 50% of your 401k to go to zero? From what I have read of you so far, I don’t get the impression that you have really experienced any significant financial loss (a job, investment, etc.). I could be wrong, and maybe you really do know how you’d react if you lost half of your 401k over night. However, in my experience, most people don’t really know how they’d handle a situation until they are actually in it. Just some food for thought….