As promised, I am going to begin to help some individuals educate themselves with a proven method of investing. The recommended book I am using is the Intelligent Investor. This book was written back in the 50s by Benjamin Graham. Warren Buffett has labeled this book as the best book on investing ever written. I strongly recommend purchasing this book and reading it cover to cover.
With that said...I am going to skip to Chapter 4 General Portfolio Policy: The Defensive Investor. First question...what is a Defensive Investor? On page 88 the book says that the rate of return sought should be dependent on the amount of intelligent effort the investor is willing and able to bring to bear on this task. The minimum return for the passive investor who wants both safety and freedom from concern. The maximum return would be realized by the alert and enterprising investor who exercises maximum intelligence and skill.
This book is basically telling you that the old theory that those who cannot afford to take risks should be content with a low return. When I went to college in my finance class you are taught that high risk = high reward. Typically this is never the case in my opinion. If it were true, then Las Vegas wouldn't exist. An example is the Rolette Wheel. Whether you put all your money on black or lucky number 7...you have greater than 50% chance of losing everything. Your reward is doubling your money or so many times your money depending on the probability of winning. However, in the long run...the probably of making money is 0%. Therefore I would label high risk = negative reward.
Same thing goes for get rich quick schemes. Why are they high risk? Well, because chances are the product is worthless, and you will lose everything. Another example of high risk = negative reward. The Intelligent Investor is letting you know that with experience and knowledge you can obtain a better reward. An easy example of this is someone who is knowledgeable about computers and knows about online banks. Typically online banks can offer a higher savings rate than your brick and mortar bank. This knowledge can be worth a great deal of money. Getting 1% return instead of .5% means you are doubling your money. This might not mean much of you have $10,000 in capital to invest, but if you have $1,000,000 it means a big difference. Earning an extra $5,000 with no additional risk is real money. I can buy two Dodge Neons with that money.
In my next article, I'll dig deeper into the Defensive Investor. I do recommend to purchase and read the book.