Retirement plan decisions made easy
Drill Down: How Much Risk Should You Take?
Telling you how much risk you should take is difficult. It is a lot like being asked if you should settle down with your current boyfriend or wait until someone better comes along. At the extremes, the advice is easy to give. If he’s a loser, dump him. If he’s hard-working, kind, honest and makes you laugh, keep him. But if he’s somewhere in between, then you have to decide for yourself.
So here’s the equivalent investment advice, starting with some guidelines.
The younger you are, the more risk you can take. Let’s say that you’re 25 years old. You can put all of your investments into stocks, so long as you can stomach some ups and downs. Even if the stock market has a terrible decade, you’ll have another three decades to make up the loss. And over the very long haul, stocks give you the highest reward.
The sooner you will be spending your money, the less risk you can take. You can’t risk a stock market downturn just before you’re planning on spending your nest egg. So people nearing retirement usually reduce the amount of risk from what they had when younger.
If you have a lot of investment assets, you don’t need to take on much risk to meet your retirement goals. This sounds counterintuitive because, if you’re well off, you can afford to lose some money. But at the same time, lower returns will be adequate to fund your retirement, so you don’t have to take too much risk.
You should not take on more risk than you can sleep with. The point of investing is not to make mathematically perfect decisions. The point of investing is to be comfortable and secure financially. If you cannot sleep at night, something’s wrong.
You will be better off financially if you can learn to live with a moderate amount of risk. I don’t know if you can live with some risk, but if you are very cautious person, you should learn more about long-run returns and see if you can get comfortable taking some risk. There really is a reward for taking risk, and few people can achieve their financial goals without some risk.
Those last two points may sound contradictory, but I do not believe they are. People can learn to accept risk without losing sleep, but it requires a factual basis. Let me give you an idea of how taking on risk can help you achieve your goals.
A Story to Illustrate the Point:
Suppose that you have to get from New York to San Francisco, and you want to get there as quickly as possible. You are presented with two choices. You can drive an old car that is likely to break down every 1000 miles, leaving you stuck for a day while the local garage makes repairs. You’ll probably be stuck two or three times on your trip across the country.
Your other transportation is a magic bicycle. What makes it magic is that it will never break down, never have a flat tire, and never throw a chain off the sprocket. As long as you can keep pedaling, it will keep rolling.
Which will be a better mode of transportation for getting across the country? The bicycle is risk free. You’ll never lose a day waiting for repairs. But… it’s a bicycle. You will average maybe 100 miles a day, so the journey will take about 29 days.
That old car? It will probably get you 500 miles a day, but the occasional breakdown will cost you two or three days, so you’re probably talking nine days. Which sounds better? A risky vehicle for 9 days, or a risk-free vehicle for 29 days?
Let’s put this analogy into concrete form. Let’s say that you want a nest egg of $100,000 20 years from now. How much should you set aside today to reach that goal? If you invest in stocks, you need to set aside $16,351 today.
If you want an absolutely safe investment, you’ll choose Treasury Bills. But then you’ll need to set aside $57,029 today because the safest investment around also has very low return. That should give you the idea that tolerating a little risk will help you to achieve your investment goals.
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Lesson 1: What the Heck is a 401k, and What’s So Great About It?
Lesson 2: Contributions to Your 401k
Lesson 3: Investments “Cook Book” Approach
» Lesson 4: Investments: How Investments Work
Lesson 5: Loans and Hardship Withdrawals from Your 401k
Lesson 9: Your 401k, Your Other Assets, and Your Life
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