People often toss around the word "risk" as if
there's only one risk we face. In reality, there are a variety of risks that
you should be taking into account when it comes to investing and planning for
retirement. Here's a rundown on the three biggest risks every retirement saver
should consider, plus advice on how to manage each one.
1. Investment risk.
Traditionally, investors have equated risk with the extent
to which an investment's price or returns bounce up and down. The greater the
volatility, the riskier the investment. And to quantify that volatility in a
mutual fund, ETF or portfolio of investments, investors typically turn to standard
deviation, a measure that calculates how much an investment's annual return
fluctuates around its long-term average annual return.
The bigger the standard deviation, the more volatile the
investment. But many individual
investors have trouble relating to this technical measure. Besides, while it's
easy to find the standard deviation for a single fund or ETF, it's harder to
calculate it for your entire portfolio.
In the financial crisis year of 2008, for example, U.S.
stocks lost 37%, international stocks slumped 46% and U.S. bonds gained 5%. If
you're considering a portfolio of, say, 50% U.S. stocks, 20% foreign and 30%
bonds, you can fairly easily calculate that such a portfolio would have lost
about 26% in 2008 financial.
There's no guarantee you'd see the same results in the next
crash, but you'll have a decent idea of how different assets have fared and how
they, and your overall portfolio, might do in future downturns.
To get a sense of your tolerance for risk -- and to see how
different combinations of stocks and bonds have fared in the past -- check out
this Investor Questionnaire.
2. Shortfall risk.
This risk measures the probability that you'll fall short of
a goal, such as being able to maintain your current standard of living during
retirement. You can assess this risk by going to a retirement income
calculator that employs Monte Carlo simulations, or hundreds of different
scenarios to estimate how often you end up with the result you want.
After plugging into the calculator such information as your
age, how much you already have saved, how your savings are invested, how much
you expect to save between now and retirement and when you plan to retire, the
calculator will estimate the probability that you'll be able to sustain a given
level of income in retirement.
If you find you have only a 60% chance that your savings
plus Social Security will generate the retirement income you'll need, you'll
probably want to save more, retire later or make other adjustments to improve
your chances of achieving a secure retirement.
If you're a nervous Nellie investor and you consider just
investment risk, you might decide to huddle in a portfolio of mostly cash and
bonds. But the returns from such a conservative investing strategy might be too
low to build a nest egg large enough to sustain you in retirement.
By looking at shortfall risk, you'll be able to tell whether
you need to make adjustments to your saving, investing strategy and anticipated
retirement date.
3. Emotional risk.
Even when we know intellectually the investing risk or
shortfall risk we face, we sometimes make emotional or impulsive decisions and,
in effect, become our own worst enemy.
Many people, for example, invest more aggressively and take
on more risk after the market's been on a big run because the giddiness of a
bull market lulls them into a sense of false security, leading them to
underestimate the risk they're actually taking.
It's only after the bull market comes to a crashing end and
they're sitting on an unacceptable loss that they realize they let their
emotions get ahead of them. This process works in reverse as well. We become
overly pessimistic after a market downturn, and invest far too cautiously.
This is a tough risk to manage. All the signals we get from
other investors and the financial press during bull and bear markets reinforce
feelings of irrational exuberance or undue pessimism. So it's easy to go along
with the crowd and invest too aggressively during good times and too
conservatively in bad time.
Advice: After you complete the Investor Questionnaire,
print out a copy and refer back to it before you make any change in your
investing strategy. A simple reminder may be enough to stop you before you do
something you'll later regret.
There are other potential risks to be sure. One example:
inflation, which has been relatively tame the past 20 years, could awake from
its slumber. But if you focus on the Big Three risks outlined above and get a
handle on them, you'll have gone a long way toward increasing your chances of
having a secure and comfortable retirement.
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