'Acceptable risk' -- the meaning varies according to investor's goals
The term "acceptable risk" has appeared in these columns when comparing the pros and cons of money market mutual funds to other investments. But, what is an "acceptable risk?"
For retirees anything less than absolute assurance that money will be available as promised is unacceptable. Retirees cannot replace capital if it should be lost. Thus, minimum risk is essential.
Unfortunately, there is no such thing as an absolutely risk-free investment because risk involves two concerns. First, there is the risk that dollars invested may not be returned. Second, there is the risk the dollars returned will buy less than the dollars invested -- even adding interest or dividends.
Stashing money in US Treasury bills, notes, or bonds will assure a return of the dollars invested plus interest. Yields on US securities have been quite high recently, but yields will continue to cycle up and down. Insured savings accounts and certificates of deposit offer similar security. Other securities backed by the US reduce to a minimum the risk of not getting dollars back.
Problems arise when an investors decides the return from risk-free T-bills or other guaranteed or insured securities isn't keeping pace with inflation. This negative real rate of return affects most persons subject to moderate or higher income taxes.
When is an extra 1 to 10 percent return worth the added risk? Any answer is a personal one.
Investment risks vary from virtually none (US securities) to wildly speculative, as in commodities and money futures. For every investor there is some level of risk that he or she can live with. A risk that is acceptable to one investor might not be acceptable to a 75-year-old retiree. The risk of losing future purchasing power may be of more concern to a younger person than the risk of not getting one's dollars back when secure investments return less than the inflation rate after allowing for income taxes.
The risk of losing purchasing power appears more formidable than the risk of not getting your dollars back in today's inflation plagued economy. The trick of investing is to balance the two risks.
You might, for example, invest in a money market mutual fund for more interest than is available on a savings account to keep up with or close to inflation. You give up some security against losing your dollars to gain a higher return.