There is so much information regarding the best investment mix for your financial goals. I challenge you to watch one episode of Squawk Box and see how long it takes for your head to spin with all of the conflicting information. On top of everything, everyone has a different idea about risk. I was talking with my colleague, Kelley, and asked her to share her perspective on how people should look at risk. Below is her guidance.
“When it comes to selecting the best investment mix for your goals, one of the first questions to be answered is, “What is your risk tolerance?” However, that’s a misleading question because that’s only referring to one type of investing risk, which is market risk. Before you make investment decisions to keep your money “safe” and avoid risk, it’s important to know about all types of risk. There are actually three kinds of risk to which investments are subjected: market risk, inflation risk and emotional risk. Every investment, including investing in a house, an education or a stock, is subject to at least one kind of risk.
Market risk is the one that gets the most attention because it’s what you suffer from when the stock market plunges and your 401(k) balance is cut in half. But if you only invest to protect yourself from market risk by sticking with bonds or CDs, you’ll suffer from one of the others.
Inflation risk is slower and less obvious. You’re not going to see a news report on how you lost 20 percent of your savings due to inflation in one day. Instead, inflation risk eats away at your purchasing power over time.
For example, if you bought a new car today, it might cost you about $26,000. If the next forty years of inflation reflect the previous forty, the same car will cost you $115,000 in 2056. It feels safer to keep your hard-earned savings in cash or CDs because you won’t ever see it dissolve in a flash crash of the market, but what you’re really doing is just trading your market risk for inflation risk.
Emotional risk is actually the biggest risk for all investors. Waiting to buy until you see that the market is doing okay has you buying high. Selling when the world seems to be going on the brink of a financial meltdown is selling low. Surely you’ve heard the adage, “buy low, sell high.” Emotional risk is what causes most people to do the opposite.
The next time you quaff about investing in the stock market because you don’t think you can stomach the risk, remember that it’s just market risk that you’re acknowledging. Avoiding it guarantees you inflation and/or emotional risk. To mitigate, you need to invest in a diversified mix of stocks, bonds and cash. The exact allocation to each class will depend on your age, investing goals and yes, your risk tolerance.
To account for emotional risk, you should set your account to automatically re-balance at least annually. Most 401k plans and online investment accounts allow you to do this, which keeps you from letting your emotions get in the way of smart investing. Instead, re-balancing can help you sell high and buy low.
We’ve answered the question of why you should invest, but keep in mind that you shouldn’t invest any money that you know you will need within the next 5-7 years. That’s best keeping in cash so that it’s there when you need it. It’s worth the risk! (Inflation risk, that is.)”