According to a Kitces article on the concept, risk literacy is, “the ability to understand the probabilities of risk and internalize them to make a good decision.”
In this article, we will explore how understanding risk can potentially help you build wealth.
- First, we’ll discuss the risk of having too much high-interest debt and only putting money in savings accounts.
- Afterwards, we’ll take a look at different asset classes people use to build their wealth and risks associated with them.
Risk and Return: How Becoming Risk Literate Can Help You Build Wealth
When a person decides to build wealth, they usually focus on two things: eliminating their debt and increasing their income. Doing these things allow them to save and invest more money.
Something that can stop them from building wealth is having a lot of high-interest debt, so their primary focus should be on eliminating it.
The Risk and Return of Having and Paying Off High-Interest Debt
Some risk is bad…but other risk is good. Let’s check out the differences and see how we can decide which to pursue.
Having High-Interest Debt is Risky
Having high-interest debt in your life makes it harder to build wealth, since compound interest is working against you. When you only make the minimum payments on your outstanding balance, you are putting your financial future at risk.
- let’s say you have $20,000 in credit card debt
- with an average interest rate of 20%, and
- you only pay the minimum payments…
- how fast will it take the balance to double?
Using the rule of 72, we can get a rough estimate of how long it will take. We simply divide 72 by the interest rate to get the answer (72/20 equals 3.6). So, in just 3.6 years, the credit card debt can balloon to $40,000.
As you can see, compound interest can be your most powerful enemy. That’s why it is important to get rid of your high interest debt quickly.
Getting Rid of High-Interest Debt
To get rid of high-interest credit card debt quickly, you should:
- Try the snowball or avalanche method to get out
- Refinance your debt by taking out a personal loan
- Increasing your income and putting the extra money earned toward debt
Personally, I refinanced my credit card debt by taking out a couple of 3-year personal loans. I went from having an average interest rate of over 20% to an interest rate of 6%, which allowed me to pay off my debt much faster.
Paying off your high-interest debt is like getting a guaranteed return on your money. It definitely puts you on the path towards building financial wealth.
Once you knock out this debt, you can contribute more towards savings accounts. But as you will soon find out, even that has risks associated with it.
Risk and Return of Putting All Your Money in Savings Account
Remember we talked about some risk being good? The below reason is why…Because sometimes no-risk is actually risky! Crazy…but true.
“The formula for calculating the risk of inflation is… (Interest Rate) – (Taxes Paid) – (Inflation Rate) = Net Result”
When you put your money into a bank that is FDIC insured, up to $250,000 of it is insured. On the surface, it’s a really safe option, but it is not a risk free money move.
If too much of your money is left in savings accounts and not invested, you run into the risk of losing purchasing power due to inflation. Inflation is what happens when prices rise over time. As a result, the dollar you have in your wallet, is worth less in the future.
According to a book I read called Wealth by Virtue, the average price of a new car in 1965 was $3,025; in 2015, the average price of a new car was $31,352. The price of a new car is ten times the amount it was fifty years ago.
Now, you might be saying to yourself that you can avoid inflation by not purchasing a brand new car. While you’d be correct, you can’t avoid purchasing items like bread, gas, and a home. The price of these consumer goods rose substantially as well.
So, what does this have to do with the risk and return of putting money in a savings account? Let’s use the risk of inflation formula above to see why it’s a bad idea to keep all your money in a savings account, especially early in your wealth building journey.
An Example of How Inflation Eats Your Savings
It’s time to really learn about risk and return…
Let’s say that you open a “high-interest” savings account that offers a 2.0% variable interest rate. How much of a return are you actually getting when taxes and inflation are accounted for?
For the sake of this example, let’s assume you pay 20% in taxes and inflation is 2%. After plugging in the given numbers into the formula, we get:
- Interest Rate – Taxes Paid – Inflation Rate – Net Result
- (2.0 – 0.4 – 2.0) = -0.4% (To get taxes paid, I multiplied 0.20 * interest rate)
- Net Result = -0.4%
Our net result shows your real rate of return. When you put money in a savings account, in today’s low-interest rate environment, you probably aren’t even keeping up with inflation.
To become wealthier, it is imperative that you look into investments where the risk and return are higher. It’s just a must.
Investments: Risk and Return
To become wealthier, you likely need to invest a significant portion of your money in order to grow it.
Some of the most common ways to invest are through purchasing and owning:
- Stocks and Bonds
- Real Estate
When you invest into the stock market, you risk losing your money. None of it is FDIC insured. But you can potentially earn way more than 2% on your investment!
In her book Quit Like a Millionaire, Kristi Shen shares her story of how she and her husband survived the last stock market crash.
She writes, “It took until March 2009 for the market to find a bottom and start to rebound. Stock markets had crumbled around 50 percent peak-to-trough, but because our portfolio was only 60 percent invested in the stock market, our portfolio was down about half of that, 20-25 percent.”
The other 40% of their money at the time was invested in bonds. This asset allocation was chosen to minimize the risk of investing in the market.
During the down period, they continued to invest in the market. It took them almost two years to recover from the crash. In the end, they were rewarded for sticking to their investment plan.
If you are going to invest in the market, be cognizant of the fact that their will be ups and downs. A disclaimer you’ll hear and see frequently when you study investing is, “Past performance is no guarantee of future results.”
Real Estate Risks
Another way to build wealth is through investing in real estate. A friend of mine has made a decent profit from buying homes, fixing them up, and reselling them.
While that’s one way to make money with real estate, another way is to own a property or multiple properties and rent them out to tenants.
- The risk in doing so is that tenants may not pay their rent on time,
- they could potentially destroy the place, and
- maintenance problems could create headaches for you.
At the moment, I don’t own any real estate, but I am reading a book called Retire Early with Real Estate by Chad Carson. It’s a great read if you want to take a deeper look at some real estate strategies that will help you increase your wealth.
Creating your own business is another common way to build wealth. The amount of risk you take on depends on what kind of business you create.
For example, when I was in college, my father created a dump trucking business. The structure of the business was a single member LLC. He invested all of his personal capital into creating the business.
- He did well to start and then the price of gasoline rose, which ate into his profits.
- Another unfortunate event that occurred was him having to let someone else drive his truck when he got sick.
- The person he let drive it didn’t take care of the truck, and it led to the demise of his business…
You may have better luck in your business ventures, but be mindful of all the risks you are taking on. Look into purchasing short-term and long-term disability products in case something happen to you.
Risk and Return…What Should You Invest In?
Deciding what to invest in is a personal choice. While some people max out their retirement funds, others like Michael Kitces decide to pour most their money into their growing their businesses.
Whatever you decide, be sure to do your due diligence! A good rule of thumb to follow is not to invest in anything you don’t understand.
When was the last time you took a calculated risk with your money? Did it pay off?
What do you consider your greatest investment?
AUTHOR Jerry Brown
Jerry Brown is an adventurous bibliophile who loves personal finance. He is the mastermind behind the blog Peerless Money Mentor. When he is not reading thought-provoking books or studying finance, he is spending time with family, biking, or taking a random adventure somewhere.