Figuring out where to put your money can be a confusing and stressful undertaking. Recently, a reader that has stayed away from the stock market asked “how to get comfortable with the thought of losing money.” That is a very good question that comes up a lot in other investing conversations I have had. It spurred me to turn my thoughts on managing Investment Risk into a post.
Understandably, people are scared to lose money. You work hard to earn it, and make sacrifices to save it. The last thing I want to do is watch my balance drop due to something outside of my control. However,from my perspective, a bulk of the fear is overblown. People feed off other peoples fear. Here are a few real world examples I have seen:
“Our friends lost half their money in the stock market”
“If you’re investing in the long term you’re crazy”
Any day of the week doomsday predictions are thrown out across a ton of media publications. If that is your only experience with the investment world, I see why you would be scared. It does not take a lot of fear to paralyze action, it is a powerful emotion.
Classic View of Investment Risk
There is not a one size fits all approach to determining appropriate investment risk. Most advisors/risk assessors use a combination of the below factors:
- Age – The younger you are the higher risk you can take on (generally)
- Years to Retirement – I think this is a lot better gauge than age, the closer you are to retiring the more protective you should be of your nest egg.
- Financial Security – If you are in a great financial position already you can afford to be more aggressive.
- Personal Risk Profile – There are tons of risk profile questionnaires that place your personality in a category. It is hard to quantify this portion, it is more of a “can you sleep at night” gauge.
From there people are placed in a investment category, the correlates to a percentage based mix of stocks and bonds. The typical ones are:
Conservative <-> Moderate <-> Aggressive
Conservative portfolios are aimed at maintaining your nest egg, and have more bonds. Aggressive has a higher stock allocation (usually 75-90%) and is aimed at portfolio growth. The A.E. household rocks a 10-15% bond allocation depending on market fluctuations. I prefer to be right in that 10% range for the foreseeable future.
Then there is the infamous “Gut Feeling” approach where you skip all of the logical thinking and select aggressive because it sounds good to you (that was my approach when I filled out my 401K for the first time 5 years ago).
Another Way to Look at Investment Risk
The historical returns from investing can’t be ignored, a balanced portfolio from 1926-2015 returned 8.7% on average (60% Stocks, 40% Bonds)*. If you are investing for the long term, investment risk drops dramatically. Markets have recovered from every correction, setback, and bubble.
*See this page for the breakdown of other portfolios and best/worst years https://personal.vanguard.com/us/insights/saving-investing/model-portfolio-allocations
Instead of worrying about short term paper losses, I look at investment risk from a different angle:
“Are my investments going to return enough so I have enough money to retire and never run out”
In other words, are my investments mitigating the risk of running out of money?
Quick peak at common return rates and what they do to a $1,000 over 30 years
The percentages were pulled on 8/24/2016 and reflect the best available for Online Savings Accounts and Long Term CDs (5 years). It is difficult to ignore the Stock Market Returns column (which does include some bonds) compared to the rest of the lot.
140 years to double your money at .06%….Please don’t keep a sizable amount of money in a traditional savings account, it is a Common Money Mistake You Can Correct in an Hour
Going to use this as an opportunity to tell a personal story that shows what can happen if you don’t build a large enough nest egg.
My Grandma is essentially broke at 80 years old. She is currently living with my parents in a spare bedroom because she could not afford her townhouse. While this is not that uncommon, the reason I bring this up is she wants to be independent, but is unable due to her financial situation. Our family has come together to help her, and that is GREAT – but its not on her terms.
At a minimum we want to be able to fend for ourself financially until the day we are both gone. I want my future children to depend on us if they run into financial problems – not the other way around.
We are counting on investing returns to expedite Financial Independence and build a pile of cash that will last forever. Without using a mix of stocks and bonds, this would not be possible at our current income projections. To put it simply, we wouldn’t be able to save enough with risk free investment gains to meet our goals. There is a bigger financial risk using CDs vs a balanced investment portfolio.
Is the thought of losing money keeping you from building a size-able nest egg?
The best advice I can give you to get over the fear of losing money is to continue reading success stories and researching historical gains. If you continually invest over long periods of time in a diversified portfolio you should be able to sleep at night.
Another method I use to ease the fear is Dollar Cost Averaging. Think about how many more shares you are buying when the price drops.
Instead of thinking “I can lose money” ask yourself “Can I afford to ignore investment gains?”
Losses aren’t real until you sell! If you can ride out the storm you technically did not lose any money on that transaction.
If you are still on the fence, build up a sizable Emergency Fund first then start moving your money into a mix of stocks and bonds. Personally, I rarely invest in individual stocks – the risk outweighs the reward for me. I am a huge fan of Vanguard funds due to their low expense ratios.
For the readers on the opposite end of the risk spectrum – take a look at My Stint as a Day Trader for some advice.
Some products that can help you:
Personal Capital: Personal Capital has a ton of great Free features, you can track your spending, net worth and even analyze your portfolio. It has top notch security and I am able to connect all of my accounts. Saves a ton of time!
Sofi – I saved a ton of money using SoFI for a Student Loan Refinance. They are great to work with, the process was super easy (compared to my previous refi) and I got a great rate. If you have student loans be sure to check them out.