What is Risk?

In our last newsletter we discussed inflation, introducing the topic of risk when referring to the possibility of earning a 13% rate of return (ROR). As mentioned last month, just about anyone would love to earn the highest return possible, but with that comes the need to understand what the overall impact of that might be, in other words, what amount of risk one is willing to take really determines the return one can realistically expect.

The word risk conjures up images of people taking on challenges that include an element of danger or uncertainty of outcome – be it a physical activity, undergoing a complicated surgical procedure, or, for our purposes, the desire to receive greater investment returns.

With investments, people who earn high rates of return usually are also willing to accept a higher level of risk. To best explain this, let’s assume the market return is 8%. For the high risk investor let’s assume they may earn as much as 20% - a 12% greater return than the market. But along with that possibility of growth, they may lose as much as 12% instead resulting in a return of -4% which means they have lost some of their principal - the money they invested.  The possibility of earning between -4% and 20%, a 24% variance, is the range, or the amount of fluctuation this high risk investor is willing to take.

Another investor may not like the idea of losing their principal, and prefers earning at least something, even if it’s only 2%. For this person, since they’re willing to accept a low return of just 2%, this represents a 6% differential from the market’s ROR, so, just like the more risky investor, this means their range of potential returns is 12%, or that they can expect a return somewhere between 2% and 14%. It is apparent from these 2 examples that when looking to minimize the downside an investor must also accept that the potential high is also reduced, although 14% is still quite nice. Thus, this investment approach comes with a smaller range of outcome possibilities.

These ranges, 24% for the more risky investments and only ½ that at 12% for a less risky investor are also referred to as the amount of volatility the investor can bear. The investment dictionary definition of volatility basically states that volatility measures the amount of uncertainty about the size of the changes inan investment’s value. Therefore, a person’s willingness to tolerate more significant changes, and more frequent changes as well, more often than not will be rewarded over the long term with a more generous rate of return.

In reality, the volatility of an investment is measured by the metrics called “Standard Deviation” and “Beta”. Standard deviation is the amount of volatility you can expect 2/3 of time from the mean. Beta is the amount of volatility % you can expect compared to the S & P 500.

Identifying a person’s risk tolerance is one of the most crucial elements in determining what types of investment vehicles, and even which specific ones, a person should include in their portfolio. How to know what your risk tolerance is will be the focus of our next newsletter.

As always, if you have any questions about this article or your investments, we welcome your questions.

How to Invest in Roth IRA, no matter how high your income

The three best advantages of the IRS are:

1. Roth IRA (Never Taxable)
2. Life Insurance (Not Taxable)
3. Estate Tax Exemptions (3.5 Mil in 2009)

One opportunity that most of us can take advantage of is transferring IRAs to a Roth IRA in 2010 when Congress has removed the AGI (Adjusted Gross Income) limitation. The best tactic for most of us is to open and fully fund a “Non Deductible” IRA for 2008, 2009 and 2010.

The maximum amount you can invest is $5,000/year (or $6,000/yr if you are over 50). In 2010 you can roll the IRAs over to a Roth IRA and pay taxes only on the earning for 2008 & 2009. Once in the Roth your funds can grow tax free for the rest of your life and the life of your beneficiaries.

Also there are no required minimum distributions for your lifetime. Pro rata distributions are required over the life expectancy of your beneficiaries. Call Quest at 781-224-3456 if you have any questions or need some help.

This could grow to 100 x your initial investment over your life and life of your beneficiaries.

What Does it Take to Double your Money

There is a simple calculation for how one can double their money; it is called the rule of 72. If you want to double your money within a certain period, you divide the number 72 by the number of years to calculate the rate of return you need to achieve your goal. Likewise, if you know how much you’re earning, when you divide 72 by that number, you will then know how long it will take (in years), to double your investments.

For example, if you have $10,000 earning 7%, you will have $20,000 in just over 10 years. If you’re hoping to reach the $20,000 mark in only 5 years, you will need to earn a 14.4% rate of return. This is a simple trick that anyone can use to quickly determine how long it may take to save for a particular purchase, expense, etc. What this doesn’t factor in is if you are contributing additional monies to the original amount, which will reduce the length of time or lower the ROR needed to achieve your goal.

(c) Quest Financial Services, Inc.

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