4th Quarter 2016
Investing Spotlight: What’s Your Risk Tolerance?
You may have heard the advice that your investments should match your risk tolerance. But what does that mean?
First, you need to define risk. Most people think of market risk – the risk that your investments will lose value. If you shift all of your investments into cash because you’re worried about the market risk of losing money in the stock market, then the value of your money might not keep up with inflation. The further you are from retirement, the greater the risk of declining purchasing power. And if you don’t build up enough savings by the time you retire, you could be exposed to longevity risk – the risk that you’ll outlive your money. You need to balance all of these risks when saving and investing for retirement.
Your tolerance for market risk varies based on your investing time frame. Will you have time to recover from any potential loss before you need the money? You need to judge your time horizon and make sure your market risk is appropriately matched to your time horizon.
You’ll generally have to accept more risk of losses over the short term in return for the possibility of higher returns over the long term. Stocks have historically performed better than bonds and cash over the long term, but have much more volatility over the short term. In the best-performing year since 1926, the S&P 500 stock index returned 162.9 percent; in the worst, it lost 67.6 percent. But the stock market returns evened out over the long term – with an 18.3 percent annualized return over the best 20 years, and a 1.9 percent return over the worst 20 years. In no 20-year time period since 1926 has stocks delivered a negative return. The performance of the S&P 500 Index is generally used as a proxy to represent the overall stock market performance.
Of course, you can’t afford to take the market risks of stocks with money you need in the next year. But if you have 20 or 30 years before you plan to retire, and if it aligns with your objective, then you may be able to afford more market risk with the potential for higher long-term returns. You can gradually shift your investments from stock funds for the long-term into bond funds and cash over the short term as your need for the money gets closer. But even when you reach your target retirement date, you could live for 20 or 30 years or more in retirement. So, you still need to invest some money for the long term, or else inflation risk could diminish purchasing power. If you are investing on your own, you may similarly need some market risk to stocks on or after your target retirement date.
If you’re less comfortable with market risk and want to invest more conservatively over the long-term, you’ll need to make some trade-offs to increase your savings in other ways, such as by contributing more to your accounts, delaying your retirement date, or getting another job to add more to your savings. Without taking on more long-term risk or saving more, you could be subject to longevity risk and may outlive your money.
For more information about investing for retirement and creating your portfolio, see our investing resources.