Monday, 1 September 2008

The smart way to get rich

http://articles.moneycentral.msn.com/Investing/StockInvestingTrading/TheSmartWayToGetRich.aspx

The smart way to get rich
To get big rewards, you'll need to take some risks. What's important is knowing -- based on your needs, your time frame and other factors -- just how much danger you can handle.

By Annie Logue, MSN Money
Feel like taking a risk in hopes of hitting the jackpot on a rocket stock?
Before you make the leap, you might want to get a grip on risk.

Risk is great . . . when you make money
Prices go up, prices go down, and you never know which way they're headed next. A lot of folks would say, well, that's risk. But really that's only half the picture. The other half is what you do in response.

"Nothing goes up forever"
After all, there's nothing wrong with risk itself. What's important is how you handle it. To know how to manage the risk-reward equation, you're first going to have to get a grip on what you're playing with -- and how much you can afford to lose.

Graphic: How risky is it?
It's pretty hard to talk about investment risk without falling into a lot of clich├ęs about roller coasters and bungee jumping and being able to sleep at night. That imagery is entertaining but maybe not terribly helpful. Instead, let's start with the basics. We don't want to lose money, right?
"Obviously, negative return is risk," says Lee Schultheis, the CEO and chief investment strategist at AIP Mutual Funds in White Plains, N.Y.
Pros such as Schultheis use some pretty powerful computer-driven tools in their analysis of risk. Here are just a few of the concepts that are important to them:
Standard deviation, much beloved of finance professors, measures how much the results of a process tend to vary. The higher the standard deviation, the more unpredictable the results.
Correlation, used by those managing diversified portfolios, tells you how much two assets move together to reinforce -- or offset -- performance.
Value at risk, often used by hedge funds, measures the likelihood that you will lose all of your money in any time period.
All three are mathematical concepts and require some comfort with statistics to calculate -- but not to understand. Each translates the uncertainties of risk into mathematical estimates of likelihood that offer a good basis for planning.

Math won't help everything
If you have an investment with a high standard deviation, close correlation to other investments or a high value at risk, you're taking on significantly more risk. If more than one of those factors is involved, watch out.
Let's say you're thinking about doubling up an investment in technology stocks. Results in that sector are going to be erratic to begin with. But because the new investment correlates positively with stuff you already own, the risk to you is much greater.
Normally, riskier investments hold the promise of greater returns over the long run. But that may not help you sleep at night.

What are acceptable losses?
Professionals will use concepts like standard deviation and correlation to balance risks in ways that can get pretty complicated. The average investor isn't equipped for that sort of thing. Fortunately, there are approaches that are a lot simpler to manage while still offering an approach that is fundamentally sound.
Edward Gjertsen, a certified financial planner with Mack Investment Securities in Glenview, Ill., encourages his clients to think about risk in a more personal way. He tries to focus their attention on their own fundamental needs.

How safe is your job?
He offers clients what he calls his seven-day cash challenge. Clients are asked to withdraw as much cash as they think they will need for all of their expenses -- coffee, groceries, whatever -- during one week. Then he asks them to report back on when the money runs out.
Very few folks make it through all seven days without a trip to the ATM.
"The ones who do it find it's eye-opening," Gjertsen says.
That's because most of us have a lot of expenses that we don't think about: birthday presents, a manicure before a party, prescription refills and the like.
"Every time somebody swipes a card, somebody's making money somewhere," Gjertsen says. "You don't necessarily realize this money is whipping through your hands."
The cash challenge helps Gjertsen's clients understand where they should draw the line on risk. Most of us do not want to gamble away the money we need to pay basic expenses and buy an occasional birthday present. But if we can take care of our basic needs, plan for college for the kids and fund a reasonable retirement, say, and still have a bit of money left over, that's different. There, maybe a bit of additional risk makes sense.
"Your portfolio should reflect whatever your underlying risk preferences are," says Leo Harmon, a senior director at Fiduciary Management Associates in Chicago.
To handle risk intelligently, you first need to make sure you can afford it. Then make sure it fits well into our overall investment strategy. Diversify. Don't bet the farm on a single sector. And recognize that it's not just how much money you'll need, it's when you'll need it.
For instance: A technology sector that sees a lot of ups and downs may be the worst possible investment for an individual who is planning to retire next year. But for the person with a 10- or 20-year time horizon, the same sector might make a lot of sense.
In the right situation, the addition of some well-managed risk makes sense and should have a positive effect on a portfolio. To profit from additional risk, though, you have to be comfortable enough to ride out the short-term fluctuations. Be prepared for some volatility, and understand that the ups and downs tend to get more extreme as the risks go up.

How competing economies help you
Meanwhile: Bear in mind that all investments carry risks of one sort or another. Just because a security has low volatility doesn't mean that there's no potential for loss. A steady loser is a lot worse than an investment that goes down a lot but then goes up by even more.
"It might not feel bad along the way because it only goes down a little bit at a time," AIP Mutual Funds' Schultheis says of the steady losers. In the end, though, a loss is still a loss.
If you think it through, risk can work in your favor. And you can still sleep at night.

Published April 11, 2008

No comments: