“You have to take risks. We only understand the miracle of life fully when we allow the unexpected to happen.”
When it comes to financial planning (and life), we need to develop a healthy relationship with risk. What is risk, and how is it defined?
Risk is all about the degree of uncertainty.
When an event or activity is familiar, the less risky we perceive it to be.
When we can understand and quantify the potential for loss, we are less fearful.
It’s because uncertainty is removed. We know what to expect and can anticipate the bends in the road. The activities and events that involve little to no risk are the routine and mundane. There is comfort in the mundane.
On the flip side, when an event or activity is unfamiliar, the riskier we perceive it to be.
When we can’t understand or quantify the potential for loss, we are more fearful.
We have no clue what to expect, and the bends in the road come out of nowhere. Uncertainty makes us feel uncomfortable and out of control. Uncertainty breeds fear.
But with risk comes reward.
Taking calculated risks can be the difference between a comfortable retirement and one filled with financial stress. On the personal side, taking calculated risks can be the difference between living an exciting life versus just existing. Like everything in life, risk requires balance. Too much risk can leave you broken. Too little risk can leave you full of regret. When it comes to investing, how can we strike the right balance?
Balancing Risk and Return
Investing in appreciating assets involves uncertainty, which, as highlighted earlier, equals risk. But there is an easy way to mitigate the risk: invest according to time horizons.
Understanding Time Horizons
There are two types of risk when it comes to investing: losing money and missing out. The risk you’re most exposed to all depends on the time horizon for a given goal. As a general rule, short-term goals face the risk of losing money and long-term goals face the risk of missing out.
Let’s say you plan to buy a house within the next year and have $100,000 saved for a down payment. Should you invest your $100,000 down payment fund in the stock market? Let’s look at the historical range of stock market returns over a one-year period.
Looking back over the last thirty calendar years, the best and worst one-year stock market returns were 37.20 percent and -36.55 percent, respectively. Putting this into real dollars, $100,000 invested in the stock market for just one year could result in $137,200 on the high side or $63,450 on the low side. While there is potential for a larger down payment, there is also a chance your down payment fund will be compromised. Thus, the potential upside is not worth the risk.
Let’s say you have $100,000 in excess savings (funds outside of your emergency savings) reserved for retirement in thirty years. Is the stock market appropriate? Let’s look back at the historical stock market returns, but this time through a different lens. When you have a thirty-year holding period, the individual year-over-year returns are of less importance. What we really care about is the thirty-year annualized return.
Over the last thirty years, the stock market has annualized at a rate of 10.61 percent. Yes, this includes the low return of -36.55 percent, but it also includes the high return of 37.20 percent. When you smooth the returns out over the entire thirty-year period, bad years are followed by good years, good years are followed bad years, and the odds of experiencing a positive return over the entire thirty-year period is strongly in your favor.
What does this mean in terms of actual dollars? If you invested $100,000 in the stock market thirty years ago, you would have $2.1 million today. Depending on how much you spend, this could provide a nice retirement. If you held the $100,000 in a savings account, you would have around $270,000 today (not enough to retire). Bottom line: when it comes to long-term goals, avoiding the stock market is the risky move.
Putting It All Together
When it comes to managing risk and asset allocation the most effective strategy is usually the easiest to implement and manage. Just follow these simple rules:
- Diversification—Invest in different types of assets (cash, bonds, real estate, and stocks).
- Match risk with time horizon—Be more conservative for short-term goals (cash and bonds) and more aggressive for long-term goals (stocks).
- Invest in consistent increments over time.
- Remain invested over the long run.
- Minimize fees (and emotions).
Bottom Line: All short-term wealth goals (within the next two years) should be in cash. Wealth goals between three and ten years should be a combination of stocks, real estate investment trusts, bonds, and cash. All long-term wealth goals should be invested primarily in stocks. By taking a goals-based approach to managing risk, you mitigate the competing risks of losing money in the short term and missing out over the long term. The biggest risk of all is to do nothing and just hope it all works out.