The objective of investing is not to make a "big pile of money." This idea may be startling to many investors. Certainly, making a fortune would be wonderful and most of us would love to have that "problem." Yet this commonly held goal is rather vague. How much is a big pile, a lot, or even a boatload? What do we need the money for? How much is enough? What are we really trying to accomplish? Without examining these questions, we are pursuing a fantasy, not a clear objective.

In finance, it is generally accepted that there is a relationship between risk and return. If you take a small risk, you expect a small return. Think money market funds that currently yield less than one percent per year. On the other hand, if you are willing to take big risks, you should be able to expect greater returns. Some bank stocks, for instance, are up over 100 percent in just the last few months. However, riskier investments bring a wider spectrum of possible outcomes. You could end up losing more money in a riskier investment, even though you expect to receive a higher return in the future for the risk you have taken. So the time frame within which you need the money becomes very important.

Lessons From the Lottery

In some ways, investing to "win big" can be compared to playing the lottery. If you go to the corner store and buy a lottery ticket, you are gambling on a chance of hitting the jackpot, but you could come away with less than you walked in with, as most often occurs. When playing the lottery, you make the conscious choice to risk losing all the money you paid for lottery tickets, in the hope of beating the (considerable) odds of winning. Furthermore, it is shocking to note that some 80 percent of lottery winners declare bankruptcy within five years! Maybe a big pile of money isn't all it's cracked up to be.

It is part of human nature to think that more is better. Yet many tales and myths explore this theme with a caveat not to overreach. Grimm's fairytale #19, The Fisherman and His Wife, is a case in point. The fisherman catches a magical talking fish, which he releases. The fish could be viewed as the fisherman's investment that, at his wife's urging, he keeps leveraging for greater and greater returns. He asks for a bigger house, then a castle, and so on. Finally, the fisherman risks too much, asks for a level of return that is clearly unnecessary and unrealistic. The outcome is the couple loses everything, and ends up back where they started.

How Much Risk Can You Afford?

The goal of making a lot of money encourages risk taking. The investments required to achieve the highest returns are usually the riskiest. Taking this kind of risk may not be what you want or need. Hopefully you know yourself well enough to determine how much risk you are willing to take, but do you know how much risk you can actually afford?

People often take a lot of risk in stocks in their retirement accounts in an effort to maximize the possibility that these investments will grow as much as possible – i.e., they will become the proverbial big pile of money. Maybe some investors have the temperament to stomach wide swings in the value of their accounts. Many people do not. The bold investor makes his risky choices thinking he has time to ride out the tough patches in the market. In reality, it takes many years to recover from large hits to the value of a portfolio. As people get older and accumulate some assets, generally they don't want to risk losing what they have. I cannot overstate the point that we need to be in touch not only with the risk that we can tolerate, but also with the risk that we can afford.

Determining the risk we can afford depends upon having a clear notion of the goal or objective of our investments. Instead of simply aiming for the juiciest or greatest returns, we need to tailor our risk to a specific goal. For instance, if you determine that you need approximately one million dollars in investments in order to retire, are already close to this amount and plan to retire in five years, you do not need to risk reaching for a big return. In fact you should be interested in protecting what you already have accumulated. While earning a return on your capital is important, preserving it is every bit as important.

The Role of Risky Investments in the Portfolio

This is not to say that you don't want riskier investments with the potential for high returns. If you need your assets to grow over time, you must have some of these. Remember the idea of the "investment menu" introduced in last month's newsletter. Selection of these higher-return risky investments must be made within the context of your overall menu, or portfolio. Then consider the amount of risk each investment "course" poses to the whole menu of your portfolio. For example, if you ask me, "Shouldn't I own gold?" the answer will be based not only on whether we expect the price of gold to go up over time, but also on what effect the addition of gold to the portfolio has on your level of risk, and how it will contribute to meeting your goals.

The goal of investing should be to earn a return commensurate with the risk that you can tolerate and afford. The goal is to preserve precious capital, grow it as needed, while taking care to manage risk. Investing starts with your preferences, goals and values. The vague goal of making a lot of money fails to take into account much of your personal situation. It doesn't encourage a discussion of risk and return, need vs. wants or what it is you are really trying to achieve. Most people would be happier making steady progress toward their vision of retirement, rather than taking much greater risks and potentially falling short. No one sets out to be like the fisherman and his wife, after years of investing, to be back where they started.