Section II - Lesson 5B
Investing Basics - Understanding Risk: The Long Term Horizon
The concept of risk, as it applies to your two investment
accounts, can best be grasped by an understanding of the following statement. In
a long-term investment program, spanning 30 to 50 years or more, time,
diversification, and the timing technique of dollar cost averaging serve to
minimize the risks of owning common stock to the point of non-existence.
Let’s compare a short-term situation to a long-term situation. Assume you have a lump sum of about $95,000 in your bank account which you know you’re going to need in order to pay off a note on your business several months from now. Imagine how risky it would be to try to put these funds to work for the next few months by purchasing, let’s say, 3000 shares of a $31 high-tech stock in the hopes of quickie profits between now and the time your note comes due. Who knows what the price of this security might be as the time approaches when you absolutely have to sell the shares to get the cash? You could take a whopping loss and not be able to pay off your business note. Buying stock, under these circumstances, is truly risky.
This situation would not even be improved if you bought shares of a diversified stock fund instead of the single high-tech stock because the timing issue remains the same. You still have the problems of timing a lump-sum purchase, timing a lump-sum sale, and exposure to short-term principal risk. If the general market drops during this period, you’ll still be in a lot of trouble. Even buying a stock fund, under these circumstances, would be risky.
Much of your risk derives from the fact that you have to sell this entire investment by a certain date. Your better course of action in this type of situation is to hold your $95,000 in an investment that doesn’t fluctuate in value, like a money market fund, or U.S. Treasury bill or bank CD. You won’t stand to earn a lot of interest, but at least you’ll get your principal back when you absolutely have to have it.
Compare this to the totally different long-term investment situation you enjoy with your investment accounts. You’re not making any one-time lump-sum purchases. Instead, you’re building wealth by investing small regular amounts, on a monthly basis, over a period of 30 years.
You are “dollar cost averaging” as we’ll discuss in just a moment. You’re investing gradually but regularly, and at various prices, over a period of 360 months or so and your purchases come to, say, about $95,000. Because each of your purchases has been small in relation to the total amount of your investment account, you’ve exposed yourself to virtually no short-term principal risk. For every month that you might have bought when prices were “high”, there were months that you bought when prices were “low.”
The long-term horizon not only eliminates the problems of timing of a lump-sum purchase, but also the problems of timing of a lump-sum sale. You’ll never be selling out your entire investment account. When you retire you’ll be taking only small withdrawals every month, while the rest of your balance continues to grow.
When you view your investment program as a 30 to 50 year scenario, you come to a much more realistic understanding of the risks of owning common stock funds.
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