Should I Payback My Loans Early or Invest? The Role of Risk on Investment. Part Two

Should I Payback My Loans Early or Invest? The Role of Risk on Investment. Part Two

This post is a part of a series on determining whether you should pay back loans early or invest.

 

Link to the rest blog series:

 

 

Editor: Paying down debt and investing wisely is one part of your financial success. The other side of the coin is earning more income. This is where your most vital professional skill, negotiation, comes into play. As a physician, you’ll be expected to negotiate often, including your salary. It’s shocking how few Physicians have any training in negotiation, which places them at a huge disadvantage. NegotiationMD.com trains physicians to become experts in negotiation, while also teaching them how to preserve relationships. Check us out. We may be the missing piece you need to truly succeed.

 

 

In its most basic form, investment is the active evaluation, management, and assumption of risk.

(You may wish to read the above sentence over and over until it becomes part of your DNA)

This simple definition of investing holds a world of information.

For instance, cash in the form of currency has no risk.

In 20 years, a 10-dollar bill will still be worth 10 dollars. Of course, 10 dollars won’t by as much in 20 years due to inflation, but the investment vehicle is sound- it’s unlikely that US currency won’t be accepted in one form or another (paper, coin, e-currency, etc.). Because cash has no risk, no one will give you an investment yield return on it.

 

 

How about a mortgage?

A Bank invests in loan to an individual. The bank assumes some risk. The person may lose their job or become disabled. There is always the chance that the borrower may not pay back the loan.

Because the bank assumes the risk, a return is expected.

In a loan, that’s described in interest and fees. If for some reason the loan is not repaid, the bank can take back the house and sell it for some recovery. This makes the loan “secured” and less risky.

 

 

How about student loans?

Students loans are not “secured”.

If you can’t pay, the bank is unable to extract the information from your brain and sell it to recover lost funds.

For this reason, student loans are riskier and have higher interest rates. These interest rates may be lowered by government subsidy, co-signers like parents, or improvement is your employment of financial condition making you less risky.

Editor: A special note about student loans. Due to their unsecured nature, many student loans can not be forgiven in bankruptcy. For instance, if you go bankrupt, the bank takes your house and the money you put into it so far. Your student loans just continue after bankruptcy, often accruing more cost. This may give you reason to prioritize early student loan payment over other loans, even if the return is not as favorable.

 

 

Bonds have many sources of risk.

One source is duration risk- the longer the duration of the bond, the greater the risk. Since you lock up the money and lose the chance to invest in better things as they come up. So longer duration bonds should pay more (but not always).

The other bond risk is quality.  Secure institutions like the country of Japan are more certain to pay a bond in full. Meanwhile, a start-up company with a shaky director structure like Telsa is less likely to pay the bond in full and demands higher returns.

 

 

What about equities or stocks?

What is the risk and the premium or increase return you get for assuming that risk of investing in stocks?

Now we get into the meat of the matter. Stocks are volatile. The price of a stock may fluctuate wildly every day.

If you look at the largest companies in the past, you’ll see Kodak, GE, Radio Shack, Enron, Sears. Go even further back and you’ll see US Steel, Pennsylvania Railroad, or various Coal or even Lead companies. Many of them are gone or shells of their former selves.

 

 

When you invest in a stock, or the whole market as part of a ETF or mutual fund you are not guaranteed returns.

You could lose quite a bit. And, you could lose the value the day before you need it.

Because stocks are risky and volatile, they demand a high premium in return.

Depending on how you look at the market, whether you include emerging markets or reinvestment of dividends, the typical long-term return for stocks is somewhere around 7-10%. Keep this extra return in mind as we dig deeper into the concept.

Now, you likely understand what I’m getting at regarding risk of various investment options and how riskier investment return higher yields, but are wondering what this has to do with paying off loans?

We'll find out that and more in the next post in the series.

 

 

Remember, the best way to have assets to invest or pay down loan is to earn extra income. Negotiating  a better physician contract is the surest route to more income. Be sure to check out out NegotiationMD.com and our educational resources.

 

 

Summation:
In this post we discussed

  • Investment is the active assumption of risk
  • The greater the risk, the greater the anticipated yield or return

In the next Post we'll discuss

  • Ways to directly compare risk and return between different asset classes
  • The concept of guaranteed return

Link to the rest blog series:

So, What do you think? Does the idea of risk as related to returns make sense? Do you find low risk investing more palatable? Can the risk be quantified between asset classes in a meaningful way? Tell us your thought in the comment section.

 

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