Why does one actually invest money?
When you invest money, you try to increase the value of your money over a certain period of time. A goal can be the first house down payment or financial security in the future. Investing money, instead of leaving it in a checking account, gives you the opportunity to reach your financial goals faster. The faster, the better.
But everything has its price, each investment is associated with certain risks.
But what exactly is risk?
Risk is the potential loss associated with any investment decision. It should be noted that there is no such thing as a guaranteed investment. It should always be assumed that an investment can lose a lot of value. In this regard, some securities have a higher risk and others have a lower risk. We will explain which securities are suitable for low-risk investment later in the article.
It is important to be aware of the following risks:
· Market Risk: Market risk is reflected in the economic performance of the market as a whole. A recent example is the market reaction after the global outbreak of the coronavirus.
· Inflation Risk: Inflation causes money to steadily lose purchasing power, usually without us being aware of it. This risk is particularly relevant when you consider that most Germans park their savings in their checking account or savings book and are gradually losing purchasing power due to the low interest rate environment.
· Concentration risk: If you invest all your money in just one security (e.g. a Tesla share) or in one industry (e.g. the automotive industry), you expose yourself to the entire risk of a default of that very investment. So, you should invest in multiple companies, industries, countries, etc. to spread the risk. This spreading of risk is called diversification. If a security or an industry generates high losses, these losses can possibly be absorbed by other securities or industries.
· Credit risk: Every company is subject to economic risk. How risky the company is, can be taken for example from a rating of a so-called rating agency. AAA is the best rating and indicates a low risk of default. In this case, it is assumed that the company will be able to repay its interest and principal. Government bonds usually have the highest credit rating, but these offer little return.
Ok, investing without risk is not possible! But can I control it?
Now that we are aware of the most important risks, it should be clear to us that investing without a certain amount of risk is simply impossible. Just like the motto: "Nothing ventured, nothing gained". But then why should we take this risk?
The more risk we take, the more return we can expect. Stocks have a higher risk than, for example, the government bonds mentioned above. In the case of a stock, the return is composed of the profit when the stock is sold (preferably with positive performance :)) and from the dividends (even if not every company pays them). Although the performance reflects the performance of the company, in the event of a bad economy or a negative perception of the company, the value of the stock can fall quickly. Since bonds have much less of this risk, we expect more return when investing money in stocks than in bonds.
If you are not an experienced investor and do not know exactly which stocks to buy or how to profit from bonds, it is better to turn to so-called "Exchange Traded Funds" (ETFs). With them you can replicate an entire index across different asset classes (e.g. stocks, bonds) without having to buy every single security.
ETFs are a cost-effective way to invest in many markets, allowing you to spread the risk of your investment without much effort or research (diversification). Therefore, ETFs are particularly well suited for long-term investments. If you'd like to learn more about ETFs, feel free to check this out.
And is our risk perception always the same?
Every investor must and should determine for himself how much risk he wants to take. A newly minted doctor will likely have a different risk perception than a 60-year-old nearing retirement.
Here it is important to remember why you are investing the money. Basically, you should not confuse your securities account (i.e. the account through which you trade securities) with your daily account. In the medium term, you should be able to do without the money you invest without getting into a financial bottleneck. The horizon of an investment plays a central role in this. Financial markets were designed to grow ever higher, even if this sometimes means that prices fall in order to rise again. As a private investor, you should therefore be aware that you can only profit from markets if you invest for the long term.
If you choose a long-term horizon of 10-15 years, you will certainly generate a positive financial benefit. Let's look at the S&P 500 as an example. The S&P 500 is the main index of the USA. In a ten-year average, it has always generated a positive financial benefit since 1948. Even after the economic crisis of 2008/09, the index recovered in just two years. This means that an investor who did not sell his securities more than neutralized his loss after only two years.
The conclusion is that you can optimize your return with an acceptable risk if you diversify your investment and choose a long investment horizon. 😊