The Risk of Not Taking Risk
April 17, 2014Back in college in the late 90’s, I learned a valuable lesson about managing risk when I got caught up investing in the dot com bubble. It was so easy to put up two thousand dollars and see it double or triple overnight. But the bubble burst a few years later and I was left with less money in my account than when I started. I cashed out of day trading, fortunately realizing before I had lost too much that this was not a viable long term strategy.
Most of us don’t trust our life savings to the stock market’s daily ups and downs but still put our faith in the market’s averages over the long term. We believe that the safe approach is to put away small amounts of our salary every year, eventually adding up to large gains over time. There’s an advantage to this because it’s easy and ensures we consistently stick to a savings plan.
But it can also lull us into complacency if we think this is a no-risk way to reach our financial goals. For example, if we’re hoping for returns of 8% per year on average but inflation runs 3%, we only wind up with actual gains of 5%. And what most people don’t realize is that even achieving an 8% return is not nearly as automatic as we might suppose. The stock market’s past performance is no guarantee it will continue to do as well. More importantly, if you have the misfortune of beginning to save when the market is in a boom but need to tap your savings during a bust, you may wind up years from now with far less than you expected.
The risk that you’ll fall short of your financial goals by investing small amounts over a long time frame is only magnified by the less you save and the larger your target goals are. One of the often overlooked advantages of instead trying to save large or very large amounts of your salary, as I recommend, is that you are able to take on less risk in order to reach your financial goals. You won’t need to trust your financial future to the hope that your investments perform as well because you’re saving enough to give you much more room for error.
As I’ve recently discovered however, having a high savings rate can also be risky in a different way because it might push you into being too overly cautious. I had amassed over $600,000 but was so worried about losing any of it that I didn’t want to invest in anything. I figured that all I needed to do was keep my expenses low and I would be all right.
Then I had a friend who is a financial planner shock me back to reality when we went over my finances and realized that most of my investments were generating less than 2% in returns! My savings were supposed to be out there fighting hard for me but I had them cowering in a corner. And I was risking my financial health if I had to withdraw too much or suffered high inflation.
I decided to re-evaluate all of my financial positions. I found that about half my assets were divided between cash and stocks (in mutual funds) at a ratio of 3:1, meaning less than ⅙ of my total portfolio was in stocks. I suddenly realized why I wasn’t generating any income here and set about putting more of this money into stocks.
I decided I wanted enough money in stocks that would allow me to retire on one million dollars (plus anything I get from Social Security) even if I didn’t contribute a single additional dollar for my retirement and even if all my other assets lost all their value. I used a simple compound interest calculator that I found online and determined that I needed about $175,000 in stocks rising at 6% per year in order to have one million dollars by the time I’m 65. So, I plan to put about that amount in stocks and keep the rest in a conservative money market account.
The remaining half of my assets were invested in two apartments that I own. Unfortunately, the rents on each apartment were well below market rates because I was concerned about the risk of winding up with a bad tenant. I did have two great tenants who always made payments on time but my friend made me realize that I needed to balance this goal with charging enough to make the apartments a good investment. Otherwise, I was better off simply selling the apartments and choosing a different investment. I plan to raise the rents on both apartments as a result and if I’m unable to find good tenants, I’ll sell the apartments and look to invest the cash in dividend stocks, which offer a relatively stable form of income similar to real estate.
After I’ve completed the changes in my investments, I’ll still be left with a relatively conservative portfolio of 30% stocks, 20% cash, and 50% real estate or dividend stocks. But I’ll be generating more income than I am now. I can also always re-allocate again if I think I need to be more aggressive.
I’ve realized after all this that in order to be financially successful, you need to both cut your expenses as well as generate enough income from your assets. Focusing only on saving and taking on too little risk in your investing strategy can be equally as bad too as taking on too much risk. And by saving more and having larger amounts to invest, you’ll be able to have more flexibility in deciding the level of risk that is appropriate for your investing decisions and be in a much better position to attain your financial goals.