Are You Taking Too Much Risk With Your Investments or Not Enough?
April 06, 2012Last week, I wrote about which investment firm is the best. (You’ll have to read the blog for the answer!) As a part of that blog, there were some questions I left unanswered. So I’ll address two of them today and the remainder next week.
Q: Do you know what level of risk is appropriate for your goals?
A: What I’ve seen out there in the real world is that most investors don’t actually know what type of investor they are. I’ve met people who call themselves conservative investors yet they have 80% of their assets in their company stock or 75% of their investments in large cap mutual funds. Not exactly conservative strategies! I’ve seen the same thing with people who self-identify as an aggressive investor who have the majority of their investments in cash.
How can you not rely on your feelings to label you as a conservative, moderate or aggressive investor and actually make a fact-based argument? This investment risk profile can help you figure out what kind of investor you are as well as what kind of portfolio you might consider building. I’ve also seen some investment risk profiles that are a dozen pages long and ask very in-depth questions about your investment history, your earliest memories about money, how you react to good news and bad news along with many other types of questions. That kind of questionnaire gets sent out to a firm that scores the profile and provides what is almost like a psychological profile of you as an investor. It’s incredibly complex and very interesting. The part that always makes me laugh is that with all of that work and nuance, you learn almost exactly what you learn from the quick investment profile I linked to above.
The important thing is that you take some time to do your homework and figure out who you are as an investor. Why? No matter your age, I can almost guarantee that you are going to see a few more incredibly good runs in the stock market; the kind of market that makes people talk about investing in stocks while they’re at kids’ birthday parties and while they’re in line at Starbucks. You’re also going to see a few more significant declines (or crashes?) in the stock market that make people want to bail out of their stock market investments. If you know who you are as an investor, you can build a portfolio that is right for you and maybe avoid the panic selling that impacted so many people in 2008-2009 or the urge to rush in and buy investments that might not be suitable for you, like we saw during the heyday of the dotcom boom. (Before it busted)
Know your tolerance for volatility and risk. Know how you’ll respond when the stock market is going straight up. Know how you’ll respond when the market is headed straight down too. Armed with this knowledge, you can build a portfolio that fits your goals and your lifestyle, and if you add a rebalancing feature to it, all you need to do is keep investing on a regular basis. The rest can happen almost automatically and you can feel secure knowing that you actually have a strategy. That alone would put you in select company.
Q: Why take on too much risk if you don’t need to? Or, are you being recklessly conservative and forcing yourself to work 5-10 years longer than you otherwise would?
A: This is more of a philosophical question, investment philosophy that is. Last weekend, there was a $500 million+ lottery. If you won and collected the $200 million lump sum, you could put that money in a savings account earning 1% and live on the $2,000,000 per year interest. For most people, that’s a great income and it would be virtually riskless. If you had that much money and only lived on a fraction of it, would you put the bulk of your money in safe investments or invest in a high risk/high return strategy? Most people would opt for a conservative model. I know that example’s an extreme one but if you could very comfortably live on your pension, Social Security, and very small (0-2% withdrawal rate) draw from your investments, why would you have 90% of your investments in the stock market? I see this on a regular basis.
The thing people are most afraid of as they approach retirement is a steep decline in the stock market eroding their wealth (well, that and the cost of healthcare but that’s going to have to be an entirely different blog post). This is where it is absolutely essential to know your numbers! How much will you receive in Social Security? Pension? Other income? How much do you spend in an average month? Really…how much? When you know your spending level and your income level, you can see if there is a gap to fill and if so, what percentage of your investments is required to close that gap. If it’s any higher than 5%, you may not have enough saved. If it’s less than 2-3%, you may be working a little too long. Knowing your numbers is the key to retiring at an appropriate time and constructing a portfolio that doesn’t have you taking on more risk than you absolutely need to.