THE twin activities of saving and investing are important for the long-term financial health of most people. But even if they are "twins", they aren't identical.
Let's, therefore, consider them fraternal disciplines with divergent risk profiles: Saving is a low-risk activity, while investing has higher risk. So, if saving is safer, why would anyone want to invest?
The reason is tied to a financial principle called the R-cubed, or RRR, or risk-reward relationship.
Contrary to widespread belief, the RRR does NOT mean that the more risk we take, the more reward we WILL receive. What it does mean, is that the more investment risk — meaning the higher price volatility — we accept, the greater the reward — in terms of profits — we MAY end up receiving.
With all true investments, there is always a possibility of failure. What might this "failure" look like?
There are three possibilities:
1. We could lose all our money;
2. We could lose some of our money; or, least damaging of all,
3. We could make money but not as much as we hoped for.
As for "success", there are two possibilities:
1. We make the expected amount of profits; or
2. We make larger than expected profits.
Probability theory tells us that PS added to PF, meaning probability of success plus probability of failure, equals 100 per cent.
When we choose to invest conservatively, because we pick investments of lower risk and thus lower volatility, our PS is rather high, perhaps 70 or 80 per cent over a single calendar year. Therefore, in this situation, the corresponding PF would be low, say 30 or 20 per cent. So far so good? I hope so.
If we, instead, opt to "reach for yield" or invest aggressively, then we will choose investments of higher risk and nerve-wracking high volatility. In this case, the PS would be low, say 25 or 30 per cent over a year. The corresponding PF would then be 75 or 70 per cent for the same period.
But even for high-risk investments, IF they are selected from a pool of high quality, well-managed investments, then as the investment time horizon stretches out, say for one, two or three decades, the PS for such extended periods rises. This means PF must fall, which is what we all want.
STEADY INVESTING
Licensed financial planners like me spend a lot of time explaining the mechanics of the RRR to regular people; we then assess their risk profiles to see if they are innately conservative, moderate or aggressive.
We usually use a risk profile questionnaire for that assessment. Yet other tools can also be layered onto our assessment process to grant us deeper insights into how clients view risk. (To read about an intellectual construct I created years ago, Google 'The Devadason W-A-N-T model'.)
Also, in last week's Money Thoughts column, I quoted Taylor and Megan Kovar's book The Money Couple and referenced the five money personalities people have, namely, Security Seeker, Saver, Spender, Risk-Taker, and Flyer.
No one money personality is better than the others. They all have pros and cons when it comes to managing money well. But it is safe to say that intrinsic Savers will prefer lower volatility investments while Risk-Takers can stomach higher volatility investments.
So, what does that mean for us?
To start with, it's vital that people do not take on more risk than they can handle because the key to long-term financial success is long-term steady investing. And a fully invested conservative person is unlikely to stay the course through tumultuous market gyrations from year to year.
Hence, we financial professionals also use the "sleep test". (Remember: Sound sleep is needed for good health.)
Specifically, we ask our clients whether they will be able to sleep through bad market downturns that adversely affect their portfolios. If they say no, honestly, the solution is to lower the blended risk level of their — hopefully well-diversified — basket of savings and investments. How?
By taking advantage of investing's fraternal twin: saving.
FINANCIAL SUCCESS
The yield we earn on our savings is at — or near — the so-called risk-free rate of cash in any country. In the United States, that RFR (risk-free rate) is the Fed Funds Rate, which is 5 to 5.25 per cent now, but that will fall once America gets its stubborn, sticky inflation under control. Malaysia's RFR gauge is our OPR, or Overnight Policy Rate, which is three per cent, for now.
So, to succeed as a long-term investor:
1. Select only high-quality investments;
2. Invest for the very long haul; and
3. Maintain large and growing pools of cash savings — both within your diversified savings and investment portfolio, and outside your portfolio in your EBF, or Emergency Buffer Fund, and perhaps even other distinct sinking funds for near-term goals like upcoming vacations.
Financial success stems from wise, courageous, and intelligent investing. But this essential discipline can only be sustained if deep pools of savings are built and maintained to support your very long-term investing journey.
I wish you great success, great wealth and most importantly, great health.
© 2024 Rajen Devadason
Rajen Devadason, CFP, is a securities commission-licensed Financial Planner, professional speaker and author. Read his free articles at www.FreeCoolArticles.com; he may be connected with on LinkedIn at www.linkedin.com/in/rajendevadason, or via rajen@RajenDevadason.com. You may also follow him on Twitter @Rajen Devadason and on YouTube (Rajen Devadason).