I wrote a recent article for ACEP NOW on how to select the right level of investing risk to reach your retirement goals. This is difficult for many investors and a worthy subject for discussion.
The more investors learn about investing, the more they realize it’s all about risk management—and the risks you face matter far more than the past or projected returns of the investment. In the words of Will Rogers, “I am not so much concerned with the return on my capital as I am with the return of my capital.”
However, it’s also important to not take on too little investment risk, as one of the most significant risks an investor faces is shortfall, or running out of money in retirement. The lower returns available on lower-risk investments may not allow your money to grow fast enough for your needs. There’s a reasonable range of risk for an investor to appropriately take, but there are far too many investors whose portfolios fall outside of that range….
Many investors prefer to invest in very safe but low-returning investments like CDs, bonds, savings accounts, and insurance-based products such as whole-life insurance. These investments appear to be safe because the returns aren’t volatile like those of higher-returning investments such as stocks and real estate. In reality, though, they can be even more dangerous. Perhaps an investor’s greatest opponent is inflation. Even inflation of just 2 to 3 percent a year presents a formidable threshold to investments that yield only 1 to 2 percent a year. Nobody likes to see their investments drop dramatically in value, but the alternative is to be forced to spend less than you would have otherwise in retirement or face running out of money if you live long enough. Investors who prefer low-volatility investments have likely never run the numbers to really understand what their investment preference means.
For example, an investor who wants a portfolio to provide 50 percent of pre-retirement income but who achieves an investment return that only matches inflation (0 percent real) and wants a 25-year career will require a savings rate of 50 percent of gross income for each of those 25 years. Very few doctors are willing to save that much of their income. Alternatively, the investor can work for 40 years while saving 31 percent of income. A more risk-tolerant investor who achieves a return that beats inflation by 5 percent, on the other hand, would need to save only 25 percent of income for 25 years, or 10 percent of income for 40 years, to have the same retirement spending level. The bottom line is that almost all investors need to take on a significant amount of risk in order to meet their financial goals….
There are many investing “products” (most of them insurance-based) that are marketed as reducing the risk in investing. However, these same products are also likely to reduce the return so much that a typical investor cannot afford to have any significant chunk of a portfolio in them. Financial theorist William Bernstein, MD, said, “There are no free volatility-reducing lunches that will inexpensively reduce your portfolio risk, and there is no risk fairy to insure the risky parts of your portfolio on the cheap. Yes, there are people who—and vehicles that—will do this for you, but they will cost you a pretty penny.”
While the general adage that higher risk equals a higher return is true, you should be aware that you won’t be compensated for taking some risks. A risk that can be diversified away is, by its very definition, uncompensated risk. An example of this is investing in a single stock or even a handful of stocks. Since you can easily buy all of the publicly traded stocks in the world using low-cost index funds, you won’t be paid an additional risk premium for investing in a single stock—even if that stock is Apple.
Read the rest of the article here, then come back and let me know what you thought.
How did you determine how much investment risk to take? Has that changed over the years? How and why? Comment below!