Inflation is a fact of life that everyone must deal with. Even when inflation is “low”, it gradually takes its toll on your assets. The result of low inflation is that your purchasing power gradually erodes even though you might have the same amount of money. In order to combat this, you have to earn more or increase the rate of return on your investments. Often a simple savings account won’t even pay enough interest to cover the losses due to creeping inflation. In that case, the only way to beat inflation is to take on additional risk to increase your rate of return.
Taking on additional risk, however, means that you could suffer other types of losses. So, in order to properly manage the additional risk, an individual must understand the different types of assets and the associated risks of investing in those assets as opposed to holding cash. Balancing risk vs. reward is often like a high-wire act but if you get it right it can help you prosper financially.
Holding Cash Money
The least risky way to invest is to put money into a bank account and leave it there. Many people wouldn’t consider this a form of investing at all but depending on the account you may receive a small amount of interest from leaving your money in that particular account.
Years ago, bank accounts offered higher rates of return than the rate of inflation to encourage people to trust them with their money, but these days people consider banks a safe place to keep their money and facilitate transactions so banks don’t have to offer much in the way of interest. One reason people consider banks so safe is that they are covered by FDIC insurance backe by the U.S. Government up to $250,000.
In addition to banks, there are other depositing options available to investors that might offer a higher rate of return than the inflation rate. One example of this is that some online brokerages offer a higher rate of return for cash holdings than a bank account. The reason they can do this is that the broker offers others lending options with your money and they tend to offer a higher return rate than the one banks offer to you. Brokerage accounts are also covered by government insurance but this time it is offered by the Securities Investor Protection Corporation (SIPC). SIPC protects against the loss of cash and securities – such as stocks and bonds – held by a customer at a financially-troubled SIPC-member brokerage firm. The limit of SIPC protection is $500,000, which includes a $250,000 limit for cash. Most customers of failed brokerage firms are protected when assets are missing from customer accounts.
Buying bonds is essentially the same as lending money to a company but just as all borrowers are not equally reliable, not all companies bear the same level of risk. Obviously, loaning money to a Fortune 500 company or the U.S. Government will be less risky than loaning money to a start-up or a local restaurant but generally the the less reliable the borrower the higher the rate of return you will be offered. That being said, buying bonds can be a relatively low-risk option with a predictable rate of return which is generally higher than just dumping the money into a savings account. The one thing that can add to a bond’s risk is if interest rates go up, the value of a bond goes down. One way to mitigate this risk is to hold the bond to “maturity”. So if you buy bonds that are close to maturing you will have a much lower risk than if you buy bonds that won’t mature for 30 more years.
Investing in Equities
Investing in equities is a riskier option than holding cash but with additional risk comes additional reward. There are a variety of ways to invest in equities with various ways to mitigate the risk. One way to mitigate risk is diversification i.e. it is less likely for different securities in different categories to all go down at the same time than it is for one stock to suffer bad management, declining market share, accident, or unique catastrophe.
The first method of diversification is to invest in an index fund. This type of fund regularly balances its account so that it holds the equivalent shares to mimic the index that it is tied to such as the S&P500, the NYSE, or the NASDAQ.
Studies have shown that if the richest people in the world had invested all their assets into the S&P500 back in the 1920’s they would have remained a the top of the list of richest people. Instead, they invested in more risky assets and their wealth eventually diminished. Therefore it is wise to say that investing in index funds is a smart move for those who are looking to get steady returns and not take on too much additional risk. What is important to note however is that investing in index funds is a long-term play and should be seen as such.
Blue Chip Stocks
Investing in some of the largest companies in the world can be a wise investment option. Blue-chip stocks tend to be less volatile than smaller companies and may pay dividends to improve your rate of return. Of course, if you invest in individual stocks you have to have a large enough portfolio to gain diversification. There are mutual funds that will invest in almost any sector of the market that you can think of including blue chips, foreign stocks, natural resources, utilities, etc.
Although penny stocks are one of the riskiest types of equity investments, they have the potential for quick rewards for a small percentage of your portfolio. This can have the effect of boosting your average rate of return and helping you to beat the effects of inflation. Because of their low piece per share, penny stocks allow investors to spread their holdings out over a variety of stocks and if chosen well can easily double or triple in value. Of course, they can also fall precipitously as well if not chosen wisely which is why you should limit your risk by only investing a small portion of your portfolio in them.
The Benefits of Risk
Taking on additional risk can be beneficial if done correctly. In many cases, the additional risk that one takes on can help not only to beat inflation but also position an individual’s portfolio to beat the market as a whole.
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