Why 'Safe' Investments Can Stall Your Financial Future

[Olga]

The Zero-Risk Bias

Hello everyone! Today, I want to discuss how an irrational and sometimes unhealthy attitude towards risk in finance and investing can lower many people's financial well-being. I’d like to share some thoughts that have helped me rethink the role of financial risk in my life, leading to a different approach to planning my future. Importantly, this shift has allowed me to earn additional income by investing in relatively risky instruments. Let's dive in.

People generally dislike risk, especially in areas where they cannot fully control or understand all possible outcomes. This is particularly true in the financial aspect of our lives. Advertisements for financial instruments often use phrases like "safe investment," "low risk," and "predictability" to appeal to this aversion to uncertainty. When investing money, we want to know exactly what we will get in return. 

For many, the mention of financial risk brings to mind casinos, gambling, and other areas where losing money is a real possibility. Consequently, when people unfamiliar with investing hear about the stock market or other risky investment opportunities, they often draw parallels with gambling. They think that investing without special knowledge or insider information is akin to guessing whether the roulette wheel will land on black or red.

Naturally, the most popular way to save money among the general public is through bank deposits. However, this conservative approach is one reason why most people will never achieve significant financial security. While high-interest rates on bank deposits might seem attractive in the short term, this is not sustainable long-term. Just three years ago, the nominal return on a reliable bank deposit was about 1% per year. Many turned to the stock market for the first time, unwilling to settle for such low returns.

As I mentioned, a few years ago, bank deposits offered a return of less than 1% per annum, and it’s unrealistic to expect current high rates to last indefinitely. The return hovers around zero. Such a conservative strategy may prevent significant losses but is not conducive to wealth creation.

To effectively build capital and increase your wealth, you need to take on risk. Let’s explore how to approach risk. Imagine I borrow money from you and leave my car as collateral. You wouldn’t lend me money at a 0% interest rate; you’d want some profit, above inflation, to ensure I return more than I borrowed. However, there's always a risk—I might delay repayment, or the car's value might drop, causing you losses. This risk needs compensation through profit, making the mathematical expectation positive on your side if you lend out many such loans over time.

Now, consider a different scenario: we bet 1,00 dollars on a coin flip. While you risk losing money, this risk isn’t compensated. If we repeat the bet multiple times, in the long run, we’d break even because it’s a zero-sum game. Many people view any financial risk as a zero-sum game, believing that to win on the stock market, someone else must lose. They see any profit as coming from someone else's pocket, equating financial risk with gambling.

However, numerous serious investment tools don’t involve zero-sum games. Their purpose is to generate profit, ensuring a positive mathematical expectation. While we can’t always predict specific outcomes, especially in the short term, we know that participating in these investments is rational. It’s not about being the smartest or timing the market perfectly but about consistently investing over time. Even if you don’t pick the best stocks, buying a broad market index through an exchange-traded fund can yield returns. Historically, all investors on the stock market have made profits, demonstrating it’s not a zero-sum game.

The modern economy is much larger than it was 100 years ago, driving the growth of stocks. This system can last as long as capitalism does. Data from the US over the past 200 years show that stocks have provided the highest returns, followed by bonds and gold. In Russia, the stock market is relatively young, but even conservative investments like bank deposits can show significant real losses due to high inflation in some years.

Adding even a small proportion of stocks to a conservative portfolio increases potential returns while managing risk. For instance, a portfolio with 10-20% stocks can grow much more than one with only bank deposits. This risk premium, resulting from the profits of companies, underscores the importance of accepting some risk to achieve financial growth.

If you regularly save money and invest it in conservative tools like bank deposits, your capital’s real growth would be almost flat due to inflation. However, using stocks, rental property, or other instruments with compensable risk can lead to significantly higher returns, even if the path is more volatile. This approach has allowed me to allocate most of my funds to risky assets for many years, ignoring short-term market fluctuations.

The market is full of doomsayers predicting crises, yet historically, ignoring such panic has proven to be a better strategy. While short-term risks exist, the long-term potential for higher returns outweighs the fear of immediate losses. This probabilistic thinking might be challenging, but it's crucial for successful investing. By focusing on the broader picture and diversifying, you can mitigate risk and achieve financial growth over time.

Final Thoughts

Taking a balanced approach to financial risk is essential for long-term wealth creation. While conservative investments like bank deposits can offer stability, they often fail to keep up with inflation, leading to real-term losses. On the other hand, incorporating riskier investments, such as stocks or crowdfunding opportunities, can significantly enhance returns and build wealth over time. 

It's important to diversify and remain patient, as market volatility is a natural part of investing. By understanding and embracing calculated risks, you can make informed decisions that align with your financial goals, ultimately leading to greater financial security and prosperity. Remember, the key is not to avoid risk altogether but to manage it wisely.