As established in the first three blogs about retirement savings, starting early and increasing your contributions are the two best ways to build your retirement nest egg. However, investment performance does have a part to play. In fact, poor investment planning may undermine the hard work you’ve done to build your nest egg if your investment choices are not consistent with your risk tolerance and time horizon.
An investor’s risk tolerance is the amount of fluctuation in the portfolio’s value that an investor is willing to withstand. It is certainly true that there are no guarantees when it comes to investing, but some investments are inherently more risky than others. The trick is to find the right combination of investments that conform to the amount of risk an investor is willing to accept.
Before we address how to define your risk tolerance and invest accordingly, let’s take a minute to unpack risk in general. At the 30,000 foot level in investing, the two major forms of risk are market risk and inflation risk. Market risk is what proves the adage that there are no guarantees in investing. It is the fact that when someone puts money in stocks, bonds, or alternative investments, the money invested may grow, shrink, or be lost altogether. The amount of market risk that exists in a portfolio depends greatly on how concentrated the money is in one company, investment type, or market category. For example, a portfolio invested exclusively in biotechnology companies carries a much greater market risk than a diversified portfolio that contains stocks and bonds, U.S. and foreign investments, big and small companies, etc.
Diversification simply means spreading market risk. By investing across multiple market categories (stocks/bonds, U.S./foreign, big/small, etc.), investors limit the impact of one company’s or one sector’s performance. Concentrating investment dollars in one company leaves an investor extraordinarily exposed to that company’s performance…think Enron, the Texas-based energy company that tanked in 2001. Investors lost their shirts due to misconduct at the executive level. It had nothing to do with energy supply and demand or a hit to the energy sector; it was just bad business. For this reason, mutual funds can be good investments to help investors diversify their assets.
Mutual funds pool investor’s assets typically into a variety of stocks, bonds or similar instruments for diversification. (In the event of a stock mutual fund, for example, the fund will acquire stock shares from multiple companies.) It is important to understand the objective of a particular mutual fund because many funds focus solely on a narrow segment of the market – large U.S. companies, small foreign companies, global bonds, commodities, etc. A mutual fund’s prospectus will provide the required details on these types of fund attributes, and companies like Morningstar perform research to analyze not only the fund’s holdings but all types of performance metrics. Selecting mutual funds in diverse market categories and/or utilizing professionally allocated funds like balanced funds or target date funds can help limit market risk and tailor a portfolio to your specific risk tolerance.
Inflation risk is roughly the opposite of market risk. Inflation risk is created when an investor chooses to accept little or no market risk. For the “investor” that chooses to hide cash in his mattress, he may be surprised to learn that he’s accepted a high degree of inflation risk (not to mention a burglar’s dream!). With this money on the sidelines of the investment markets, natural monetary inflation is slowly reducing the value of each dollar. If the inflation rate averages 3% over a 10 year period, that mattress stash lost more than 20% of its value in those 10 years. Same dollars…just worth less money.
For these reasons, the investment’s time horizon is critical to understand when determining the amount of risk an investor should be willing to accept. In other words (1) when do you need the money, and (2) when you need it, do you need all of it?
Previous posts have dealt with the importance of creating the longest possible time horizon for retirement investing. That time typically provides insulation from temporary market movements. For example, most retirement plan investors remember the beating their account balance took in the Fall of 2008. It was rough, no question about it…no one likes seeing their balance drop 35%-45% or more. However, that drop cannot (well, should not) be viewed in a vacuum. One should consider the impressive gains from the years preceding and now the years since 2008. For the 40-year-old (with 25 years left to save for retirement) to base her risk tolerance on the memory of that one market drop, she would be negating the long history of the market that indicates market growth over most 5 year periods, much less 25 years.
What the 2008 market drop can help us put into perspective is how we allocate our money over the accumulation years. For the 62-year-old who had not adjusted his investment allocation since the nineties, 2008 wiped out a good portion of the nest egg he hoped to be using in a couple of years. Chances are, his retirement plans at age 64 quickly changed to 68 or later. Could he have foreseen the 2008 crater? Most did not. Could he have reallocated his investments over time to reduce his exposure (market risk) in his final few working years? Absolutely, and it could have limited his loss to something much more manageable.
One trap that snags retirement investors is this idea of investing “through” retirement. Often 401(k) participants consider funding their nest egg to a certain age, commonly 65. However, retirees are living longer than ever, so that nest egg will need to stretch for 20 or more years. This means that a strategy that continues to take advantage of the market is likely preferred over succumbing to the inflation risk of an all-cash portfolio.
So how do we determine our risk tolerance and ultimately our appropriate investment allocation? There are many tools that can help you make those decisions including target retirement date investment funds specifically designed for retirement savings or asset allocation questionnaires that evaluate your timeline and attitude toward risk, but there is no match for working with a reputable financial advisor who can walk with you in each stage. For the same reasons we need doctors and lawyers, mechanics and plumbers, or accountants and IT professionals, it often takes a trusted person who knows us and our goals to help coach us to success in the retirement planning process.
Rather than just a shameless plug for Taylor Wealth Solutions and our industry colleagues, this is a recommendation that may mean the difference between years of worry and second-guessing and years of confidence knowing you have a road-map and a resource for when life’s detours occur.
I hope this retirement plan series has inspired you to (1) begin your retirement savings if you haven’t already, (2) save as much as your budget will allow, and (3) invest according to your risk tolerance and retirement time-frame. If you’re like me, having the right information doesn’t always translate to the right action, so I hope you will also allow a trusted advisor to assist you along the way.