Before you ask “how much risk should I take with my investments?”, you should be asking “do I need to take risk with my investments?” Determining the appropriate risk tolerance for your retirement investments is one of the biggest financial decisions you can make. Too little risk can cause you to fall short of your goals, while too much risk can cause swift, massive losses in your portfolio, right at the time you need the money.
How do you find the appropriate risk tolerance for your situation? Risk tolerance comes down to your need, ability and willingness to take risk. We’ll start by focusing on the need to take risk. You’ll learn how you might have no other choice but to take on risk.
I’ve come across many people who don’t like the idea of investing in the stock market because they are uncomfortable with the risk. Unless you already have or will inherit a sizable portfolio, make gobs of money, or have passive income sources to provide for retirement, you have no choice but to take on risk. If you’ve already accepted your need to take on risk, then hats off to you. Most of what follows will be good reinforcement for you. For those of you too timid to invest in the stock market, pay careful attention.
How do you do determine determine whether risk is necessary in your portfolio?
First, use Ninja Piggy’s retirement calculator to determine your portfolio value needed in retirement. Take the portfolio value needed in retirement and subtract the value of your current portfolio. Then divide the result by how many years you have until retirement. That's how much you would have to save each year if your portfolio generated 0% returns.
Let’s look at an example. Say, after plugging your info into the retirement calculator, it says you need $1,200,000 in order to retire. Let’s assume you have 25 years left until retirement and you’ve already saved $200,000. You would take $1,200,000 (amount needed) and subtract $200,000 (amount saved) to arrive at $1,000,000. Then, you take the $1,000,000 figure and divide it by 25 (number of years until retirement), arriving at $40,000. What does the $40,000 represent? In this scenario, $40,000 is the average annual amount that would have to be saved to reach the $1,200,000 goal, assuming 0% returns. Pretty daunting number right? Whether your specific number is higher or lower, chances are you are looking at an unattainable number. Ok, now what?
Remember, the big assumption here is 0% returns. With interest rates at historic lows, you might be lucky to squeeze out around 1% in a “risk-free” savings account, but 1% isn’t going to cut it in helping you reach your long-term goals. Fortunately, you don’t have to settle for such meager returns. By accepting risk in your portfolio, you can allow the stock market to do some of the heavy lifting, helping you close the gap on reaching your goals.
Trillions of dollars (that’s a really big number) around the world currently sit in negative interest rate bonds. Stop and think about that for a minute. Holders of these bonds are essentially accepting a guaranteed loss (they will get slightly less than what they put in if they hold the bond to maturity). And you thought there were no guarantees in investing? Things aren’t a whole lot better in the US, with the 10 year Treasury yield hovering around 1.6%. Why are all these numbers important? Interest rates paid on conservative savings accounts are all tied to these interest rates, meaning you aren’t going to get paid much if you want to put your money in something safe.
I find the above chart fascinating. It amazes me how much a difference 1% can make over the long run. If you can’t save enough for retirement (in 1% savings accounts), then you have no choice but to invest in risk assets, like stocks. The chart lines are straight, smooth, and upward sloping, just like the real world. Ok, so maybe the real world doesn’t provide such smooth returns, but the returns shown aren’t completely unrealistic. While we can’t just look at the chart and pick the percentage return we want, we can control whether we are giving our portfolio a chance at higher returns, compared to a savings account. We’ll eventually look at how much risk you need to take, but the clear message here is the need to take risk in the first place.
Taking on prudent risk can be one of the best financial decisions you’ll make. There are many factors involved to determining the appropriate risk tolerance for your given situation but the often overlooked first step in the process is determining the need to take on risk. As you’ve learned here, you may have no other choice but to take the leap. Not including risky assets, like stocks, in your long-term investment portfolio exposes you to the increased risk of not reaching your goals. That’s a risk, you can’t afford to take.