Friday, November 30, 2012

To Risk or Not to Risk…

“October is one of the particularly dangerous months to speculate in stocks. The others are July, January, September, April, November, March, June, August, December and February”….Mark Twain

All investments carry some type of risk. Today, I am going to focus on risk as it is measured by standard deviation (SD). Go on, keep reading. I hope I can make this an understandable concept!

Let’s use the example of choosing to invest between Product A and Product B. Product A has an expected rate of return of 4% with an SD of 2%. This means that about 2/3* of the time, this investment is expected to return between 2% and 6% (plus or minus 2%).

Product B has an expected return of 10%, but the expected SD is 20%. This means about 2/3 of the time Product B should return -10% to +30%.

In dollars, a $10,000 investment in Product A would be expected to grow in the range of $10,200 to $10,600 (again 2/3 of the time) over a one year time period. Product B’s return would result in a range from $9,000 (a $1000 loss) to $13,000. Product B has a greater reward potential but also greater loss potential than Product A. It is clear that Product B is “riskier.” Note: 1/3 of the time the gains and losses are even greater.

Another consideration to think about: if you had to liquidate your funds to raise money, you may have to sell your investment for less than your original investment. Understanding this concept is very useful in helping you determine what an appropriate investment would be.

The moral of this blog is to make sure you fully understand the risk you are taking before you make an investment. If you have the time and the temperament to take on risk, that is okay. The objective is to have all the facts in order to make the most informed decision.

In my next blog we will discuss the meaning of volatility.

*In statistics, the 68-95-99.7 rule — or three-sigma rule, or empirical rule — states that for a normal distribution, nearly all values lie within 3 standard deviations of the mean. About 68.27% (2/3) of the values lie within 1 standard deviation of the mean. Similarly, about 95.45% of the values lie within 2 standard deviations of the mean. Nearly all (99.73%) of the values lie within 3 standard deviations of the mean.

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