My neighbor called me a few Sundays ago to tell me that she was fed up — fed up to “here.” She had lost a lot of money in the stock and bond markets – on paper. The financial markets were in the midst of a steep decline. My neighbor hadn’t yet actually sold any of her investments.
“This is no way to live,” she told me, “I need the money.” She said. “But,” I said. “No!” she interrupted, “I’m selling everything tomorrow. And you can’t stop me.” The markets quickly turned around and shot up. My neighbor sold nothing and is happy again. This is a tale often told.
Embedded in this anecdote is a lesson.

Investments that provide good and even great returns must have the potential to decline in value, and on occasion they should.

We invest in stocks and bonds (or real estate, private businesses, vintage baseball cards – whatever) to make money, plus often other reasons, like to have fun. How much money do we want to make? It depends. If we invest in a bond that pays us 5% a year, then we’ll make no more than 5% a year. If we invest in a stock, the sky, theoretically, is the limit. Maybe the stock will go up $1,000 or $10,000 dollars this year — or not.

Suppose we invest in something that has no risk, or almost no risk. This means that we are guaranteed to receive our money back plus our return on time, and we know that we will get paid. We KNOW how much we’ll make, and we can sleep soundly at night assured that our return will be complete and prompt. Investments like these are called “riskless,” and typically they are U.S. government bonds. Sidebar: Even riskless investments are impacted by inflation, but that’s another story for another day.

Put simply, “risk” means the likelihood of loss.

How much money will we receive for a riskless investment? Probably not so much, because if we are totally guaranteed our investment plus profit, why should we also deserve a big windfall? In a rational marketplace, we don’t deserve the windfall, and 99% of the time we won’t get it.
If we want to make more money, if we want the hopes of a windfall, we need to invest in things that have risk. Put another way, we are compensated for taking risk.
If we invest in things that NEVER lose value, that are incapable of declining, these things are riskless and our returns will be small, often very small. But if we want bigger returns, we NEED to invest in things that have risk – things that, on occasion, decline in value, sometimes by a lot. Like stocks, or real estate or your friend’s new restaurant.

Does this mean that we are destined to lose money? It doesn’t. Like my neighbor, if we weather the declines, we are likely to be very happy – but only IF we invest in the right stuff. This means that before investing your money in your friend’s restaurant, be sure he has successful experience in the restaurant business.