Congress designated April as Financial Literacy Month in 2004 in an effort to highlight the importance of financial literacy for all Americans, especially young adults. Investing is a key element of financial literacy and essential to wealth accumulation. While making investments is relatively easy, particularly now in the digital age, deciding which investments you should make remains quite challenging. The following concepts are particularly important to understand if you’re new to investing:
- Risk vs. Return
- Risk Tolerance
- Familiarity Bias
Risk vs. return
Investors naturally want the highest return they can get on their investments for the level of risk they’re willing to accept. They would be happy with a portfolio of low-risk, high-return investments, but such investments are few and far between. More often, there is a correlation between risk and return in a competitive marketplace whereby investors are willing to settle for lower return for lower risk or are willing to take on higher risk for the prospect of higher return. If the average annual return on a particular stock is 10% over a long period, and the average annual return for a bond is 5% for the same period, the risk of investing in the bond is probably less than that of investing in the stock.
Bear in mind that the risk/return trade-off is only a general rule based on past performance, not a prediction of future performance. The return on an actual investment is never completely predictable, although analysts consider some investments to be risk-free for all practical purposes. At the other extreme, an investment that advertises an annual return of 30% should raise a flag as being extremely risky, even if the exact nature of that risk isn’t immediately apparent.
Risk tolerance is a measure of the risk you’re willing to take with your own money. A low tolerance for risk means you only want to make safe investments, while a high risk tolerance means that you’re willing to put your investment money at higher risk in pursuit of higher reward. An investor with a low risk tolerance might want to invest in CDs and money market funds, which have predictable performance and are secured by the federal government. On the other hand, a high-risk investor might prefer to invest in growth stocks, which are more volatile and have little security.
People who have disposable income to invest are likely to have a higher risk tolerance than those who invest their nest egg. No one wants to lose money on investments, but the investor with disposable income is in a position where losses will not affect him or her as much. Investors tend to become more risk-averse over time as they get closer to retirement, when they will have to draw on their investments and will be less able to replace their losses with income.
Familiarity Bias is the tendency of people to prefer something that’s familiar over something that isn’t. While this tendency exists in virtually every walk of life, it’s particularly evident when it comes to investments. Investors generally have a strong inclination to invest in companies they know, whether it’s a company they work for or one whose products they use.
Assume for this example that you ask a large group of investors to choose between buying stock in a well-known company and buying stock in an obscure company. The majority of those investors might choose to invest in the company whose name they recognize, regardless of the actual merits of the two stocks. Familiarity bias thus tends to prevent investors from analyzing the potential of lesser known, though perhaps more promising, investment candidates.
Diversification is an investment strategy based on the premise that you shouldn’t put all your financial assets into a few investments, even if you firmly believe that they are the best options available. The aim of this strategy is to spread your risk and mitigate your losses due to a bad result or two.
Imagine if you could perform a comprehensive analysis of all the stocks in the world. Out of that whole universe of stocks, you determine that investing in company XYZ would be your most profitable choice and decide to invest all your money in that company. Despite your confidence in XYZ, the stock could perform badly, causing your entire portfolio to lose value. Compare this strategy to one of diversification in which your portfolio contains 10 stocks, including XYZ. Your investments in the other nine stocks could offset a poor performance by XYZ.
Diversification doesn’t just mean that you invest in different stocks; you also need to select investments that aren’t subject to the same risks. Assume for this example that you have multiple investments, but they’re all in real estate. A national housing crisis like the one that affected the United States in 2008 would damage your portfolio because all of your investments face the same risk. When pursuing a diversification strategy, it’s crucial that you invest across different asset classes.
Professional investment advisers generally provide their services in exchange for a fee or commission. A fee is a fixed percentage of the portfolio’s value, while a commission is a percentage of the value of each transaction. This difference can profoundly affect an adviser’s rights and obligations toward the investor, so understanding the difference is essential when selecting an adviser.
Advisers who charge a fee have a fiduciary duty to their clients that takes precedence over any duty they have to another party such as a broker or dealer. That means they must always put their clients’ interest first, so they can’t sell any investment products that run contrary to the clients’ needs. The biggest drawback of fee-based advisers is that they collect the same fee from you whether you take their advice or not.
Commission-based advisers have a legal duty to their brokers and dealers, but not to investors. However, you pay them only when you execute a transaction. The main drawback with this model of investing is that it can encourage advisers to engage in active trading, even when that investment style isn’t in the investor’s best interest.
Figure's goal in promoting Financial Literacy Month is to provide you with the information you need to make better financial decisions. Figure also provides innovative loan products for borrowers.