Conventional wisdom says the youngest investors can assume
the most equity risk in pursuit of higher returns because they are furthest
from retirement and have the most time to recover any losses from bear markets.
Although mathematically true, that doesn’t necessarily mean it’s OK to risk
losing all your money.
Rules of thumb like “100 minus your age” (meaning
25-year-olds would put 75% of their assets in stocks) and target-date funds
(which are the default option in many 401(k) plans and which start out
stock-heavy and shift toward conservative asset allocations closer to
retirement) can leave some newbie investors dangerously overexposed to equities.
When deciding how much to invest in stocks, your first
consideration should be how comfortable you are with risk to begin with. This
is what’s known as your “risk tolerance.”
Notoriously Bad
The problem: Investors—particularly young ones—are
notoriously bad at predicting how much money they are willing to lose.
Compounding the problem, young investors, due to their lack of experience in the
markets and overall financial illiteracy, tend to misjudge how much risk they
are actually taking with their portfolios.
The best measure of your risk tolerance—and the true test of
what kind of investor you are—is how you actually behave in a bear market.
That’s why it is recommend that young investors start with a
portfolio that’s roughly 50% stocks (split evenly between foreign and domestic)
and 50% U.S. bonds until they experience their first bear market. If you panic
and retreat to cash, you may want to dial down your stockholdings to 30% or 40%.
Conversely, if you continue systematically investing, you may want to go 60% or
70% stocks.
The more investing experience and assets you accumulate, the
more risk tolerant you are likely to become. But there is no need to swing for
the fences. Most 25-year-olds would do just fine if they invested at least 15%
of their salary every year until retirement in a portfolio composed of just
three index funds—a U.S. total stock-market index fund, an international total
stock-market index fund and a U.S. total bond-market index fund—held in equal
proportions and rebalanced annually.
Simple, Not Easy
As simple as it sounds, though, it’s not easy for young
adults to save that much consistently, especially when they also need to pay
down debt and establish a separate cash account for emergencies.
Young people should start investing their 401(k)s in a
conservative mix of one-third stocks, one-third bonds and one-third inflation
hedges, such as Treasury inflation-protected securities. Only after
accumulating perhaps six months’ income in this “starter portfolio” should they
start raising their allocation to stocks.
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