BNA Participants

Investing is the act of balancing risk and return. Risk and return are estimates of the probability and magnitude of a potential loss or gain. Estimating the probability and magnitude of a potential loss or gain is subjective and requires some knowledge of the investment under consideration. While you don't have to be an expert, you do need to know what you're getting yourself into. To do this, you need to be able to answer the following questions:

If you can't answer these questions, either do more research or move on to another investment. If you can answer these questions, the potential risks and rewards of that investment can be analyzed using a simple spreadsheet.

For example, if you invested your life savings in a single penny stock in the hope of finding the next Microsoft, your chances of being successful are low while your chances of a severe or total loss are high.

Magnitude of Loss	Probability of Loss	Magnitude of Gain	Probability of Gain
High	High	High	Low

Based on many years of experience, I know that the chances of obtaining a 1,000% or more gain on a penny stock are very small. I am also aware that penny stocks are sometimes subject to price manipulation and occasionally outright fraud. This combined with the tenuous hold that many very small companies have on solvency, suggests a high risk investment where the odds of a substantial gain are low. In my mind, this precludes the possibility of a large investment.

Let’s take a look at the same example, only this time you invest $500 instead of your life savings.

Here the odds would still be against you but your potential loss would be minor. If you had a strong opinion about the company, it might be worth the gamble.

A more realistic example of balancing risk and reward would be if you were to buy 5 widely diversified stock based mutual funds with the hope of obtaining a 10% average annual return over the course of 20 years. Here the probability of achieving your objectives would be reasonably high, while your chances of total loss would be low. You would still, however, be subject to substantial levels of market risk. (See Section 3)

While there is considerable disagreement about the long-term average annual return of the U.S. stock market, most estimates are between 9% and 11%. (Stocks for the Long Run, Jeremy Siegle, 1993, 2002; All About Market Timing, Leslie Masonson, 2004). These returns are based on conditions that have existed in the past, most notably a growing U.S. and World Economy. There is no guarantee that these economic conditions will continue. I personally, however, see no reason why they will not. I, therefore, believe that it is reasonable to expect that the long term historic market return on broadly diversified stock based investments will at least equal those of the past. Others, of course, may disagree.

If you invest in 5 widely diversified mutual funds, you could easily have exposure to well over 100 individual stocks. To experience a total loss, all of these companies would have to go bankrupt. Barring some type of global economic disaster, this is extremely unlikely to happen. This is not to suggest that mutual funds are risk free investments. They are not. There are substantial risks associated with investing in mutual funds. The primary purpose of this course is to teach you how to identify and manage these risks.

To complete our discussion of risk and return, let’s assume that you invest your savings in a 3 year treasury note yielding 4%. The U.S. government is not going out of business, so there is virtually no chance of the note defaulting. This would normally be considered a risk free investment, but is it really?

The downside here is that your return could be so low that you are barely keeping pace with inflation. If your note is yielding 4% and inflation is 3%, your inflation adjusted return before taxes is 1%. After taxes it could be .75% or less.

When investing for retirement, you should seek out investments where the probability of moderate long term gains are high and the probability of a severe or permanent loss are low. This means a balance between risk and return. Too much of the wrong type of risk could wipe you out. Too little risk and you may be needlessly sacrificing return.

Retirement investing is a long term proposition, so you need to maximize your return to the extent possible. Even relatively small differences in return can be greatly magnified over 20 or 30 years.

The figure below illustrates what $100 invested 24 times per year would grow to over the course of 30 years at a constant assumed return of 10%, 8% and 5%.

1.Using the spreadsheet below, rate the risk and return characteristics of the following investment:

You are approached with an investment opportunity in a start-up company where the minimum initial investment is $100,000 which represents ½ of your savings. If the new company is successful, you believe that the payoff on your investment will be 100 to 1 and your $100,000 will grow to $10 million. However, you also know that almost all of the companies who have tried similar concepts have failed. You estimate your chances of a total loss are 30 to 1.

3.The same criteria applies as in the previous example except in this case, the minimum investment is $1,000. You decide to buy 2 units using 1% of your $200,000 liquid net worth. Please complete the following risk return spreadsheet.

5.You buy several broadly diversified stock based mutual funds that you intend to hold for 15 years. You are aware that the very long term average annual return on the U.S. Stock Market has been around 10% but you would be happy to receive an average return of 9%. You are also aware that due to the diversity inherent in mutual funds, your chance of a total or permanent loss are low. Please complete the following spreadsheet.

7.You hate risk and invest all of your savings into a two year CD yielding 3%. You know that the inflation rate over the past several years has also been 3%. Please complete the following risk reward spreadsheet.

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Retirement Investing Overview—Section 2