Have you ever thought about what you’ve been taught about the concept of risk/reward? You know, the idea that in life, the more risk you take, the higher your potential reward, as well as your greater potential for loss.

Like a baseball player who tries to hit a home run every time at bat; he will end up striking out many more times than the average player who swings more conservatively, but he may end up hitting more home runs as well.

Like the investor who only buys stocks in new companies; the potential reward of investing in the next Microsoft at the beginning is there, but you will also experience the loss of some or all of your principal much of the time. I’m sure you’ve heard this a million times: You have to take some extra risk to get higher rewards!

In general, all of the above statements are true. But there are other kinds of risk. For example, the risk of inflation destroying the purchasing power of your money is another type of risk that is often completely ignored.

If you have been breathing at any time in the last couple of decades, you know that prices go up for virtually everything, year after year. And, if you have your money invested in certain ways, you may find that while you’re earning interest, you may not be increasing your real purchasing power.

This risk cannot be ignored. If you are earning 4 percent (before taxes) on your money in the bank, and if inflation is averages 4 percent … you’re losing money every year when you figure in taxes.

Here’s why:

Before Tax Earnings on CD: 4 percent

Less: Tax Rate Estimate: 20 percent .80%

Net Earnings after Taxes: 3.20 percent

Less: Inflation: 4 percent

Actual Rate of Return (Negative): (.80 percent)

The (parentheses) mean that the rate of return is negative! That means you’re earning less than zero. You’re losing real money. Even though you’re not losing principle, you are losing purchasing power which has the exact same effect as losing principle. If your money is worth less, it’s the same as having less money.

Now, let’s discuss the only risk you may be taking, that violates the rules of risk/reward.

A risk, which is the most common risk I see people taking, and that offers a much greater chance of loss, without the equally greater chance of making money. What risk is this? The risk of not being diversified.

Diversification is simply the concept of not putting all your eggs in one basket. I know this sounds like a kindergarten lesson, but please bear with me. Even though being diversified sounds like a basic foundation of your investments, I will tell you that over 90 percent of the new clients we see are so poorly diversified that they are at great risk.

Remember a few years ago all the people who lost their life savings by having everything tied up in their company stock? This lack of diversification can be the most deadly risk you can ever take.

You must be realistic in your assessment of how you’re diversified. You cannot think you’re safely diversified if you have money in six different banks. While you’ve diversified amongst banks, you are not diversified amongst types of assets.

True diversification consists of being diversified by the different types and forms of investments. For example, someone who has money split up between bank CDs, annuities, life insurance cash values, stocks, bonds, real estate, foreign instruments, etc., etc. … is true diversification!

Look at this example of how splitting up your money into different asset types could add incredible safety.

Let’s say an investor has $100,000 to invest, and was thinking about putting the money in the bank, or splitting it up into five $20,000 chunks. And, let’s further assume that two of the five investments in the diversified option don’t make any money.

Invest $100,000 @ 6 percent for 20 Years = $320,713

Compared To Diversifying Over 20 Years:

Invest # 1 – $20,000 @ Total Loss = 0

Invest # 2 – $20,000 @ 0 percent = $20,000

Invest # 3 – $20,000 @ 5 percent = $53,065

Invest # 4 $20,000 @ 10 percent = $134,550

Invest # 5 – $20,000 @ 12 percent = $192,926

Total: $400,541

Diversifying in this example can provide an additional $79,828. Do you see how, even though one investment was a total loss, and one made nothing, this investor still made more money? Are you truly diversified? Do you really know?

I truly believe one of the best ways to get ahead is to plan. Set yourself up so that you can take care of yourself. Are your plans set up to deal with an unexpected change in your life? Do you have contingencies, Plan B, if all you’ve known changes drastically? I can tell you is that being prepared may be infinitely better than being skewered.

Troy Neff is managing director of Advanced Retirement Solutions. He also hosts “The Troy Neff Show” each weekday 6 to 9 a.m. on WCWA 1230 AM. He may be contacted by e-mail at Troy@TroyNeff.Com.

This entry was posted on Wednesday, August 30th, 2006 at 12:00 am and is filed under TFP Version 1.
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