You already know that every investment entails risk. Get too risky with your portfolio and you stand the chance of losing all or most of what you’ve worked so hard for. If you do that, it could have a life-changing impact for the worse on you and your family.
On the other hand, if you keep your powder too dry for too long you may not earn enough on your money. If that happens you might find it impossible to reach your financial goals. That could also result in a life that is less than all it could be for you and your clan.
With so much going on and so much at stake, how do you find the right balance?
In my opinion, there is a 5-step process to solve this:
1. Understand Your Financial Needs With An Air-Tight Emotional Filter
I’m going to ask you do something that’s really hard to do; suspend your emotional self for just a few minutes. In fact, pretend you are Spock of the USS Enterprise and feel (almost) no emotions. Totally see yourself as that pointy-eared hero for just a minute. Stay with that image and coldly write down all your long-term financial goals.
Within that list of ambitions, pick the one that is furthest away on your timeline– probably retirement. Still pretending you are Spock, match the investments that are best suited to achieve your goal. It will probably include growth investing (the stock market).
I say that because growth investing (growth mutual funds, ETFs and/ or stocks) have historically enjoyed much better returns than bonds or cash. That’s no guarantee of future performance of course. But because we have decades and decades of history, it’s reasonable to expect that if you want to invest for 10 years or more, the market is a good alternative.
2. Review The Facts.
Keep that image of Spock in your mind. Now let’s understand the financial risks associated with various investments. Here’s a graph showing the ups and down of stock, bonds, and a mixture of both over different periods of time:
Look at the far left. If we just focus on equity (green), we can see that in any one year, the returns are all over the map. Since 1950, the best one year return was a whopping 51%. But there were disappointments too. The worst the market did in any one year was lose 37% – that’s going to ruin anyone’s weekend. This is not to say what the market will do. But it’s a good indication of what you need to prepare for.
Now look at the bars in the third group over from the left. This represents the best and worst 10 year period. If we examine that graphic, things look a little more stable. The best return was 19% per year on average and the worst was -1% per year on average. There is still a wide variance but certainly not as wide as the one year swings.
If you examine the top visual in yellow, you can see that over 20 years, equity outperformed bonds pretty handily. This is why I suggest that equity may have a place in your portfolio if you are trying to solve for long term financial needs.
3. Acknowledge Your Feelings
Look back to the graph that shows the best and worst annual returns since 1950. While your intellect can understand the graph that displays the 10 year average, your emotional self has to deal with the annual returns and that can be tortuous.
Abandon your Spock now, and really try to imagine how you’d feel if you had to go through the gut-wrenching experience of a severe market downturn in any one year (or longer).
Be honest with yourself and try to really feel it. Don’t let your intellect try to temper your emotional truth. Think back to the last time you saw your investment account lose significant value. Was it extremely uncomfortable or not? Be honest and don’t hold back. Write a few sentences about how you felt at the time or about how you’d feel if you had to go through something like that now.
At this point, you understand what you need to do. At the same time, you get a sense of how you might feel about it if things get rocky. You can probably see the conflict. Good.
The trick now is to find a balance. In my experience, the easiest way to do that is to run a financial plan and re-run it each year. Your financial plan shows you whether or not it’s likely that you’ll reach your financial goals based on how much you save, how much you spend, how much you invest and how you invest.
If your plan shows that you have a high probability of reaching your goals, your fine – don’t change a thing. If you need to earn a higher return, spend less, save more or delay retirement, your plan will tell you.
You get to decide and find a balance that you can live with based on the numbers. This is far better than making investment decisions in a void.
5. Check In
Balancing risk is not a one-time event. It’s important to check in with yourself from time to time. Re-run your plan each year and re-evaluate your goals. See how you are tracking financially and at the same time, check in with how you feel about what’s going on. Are you comfortable with your investments? Are you still willing to tolerate the ups and downs? If not, that’s fine. Just redo your plan, make changes and understand the possible consequences.
Everything you do and every decision you make has risk. When you say “yes” to one thing you say “no” to something else and you can’t be sure which would have had the better result.
When it comes to investing, this uncertainty sometimes causes people to freeze up. Rather than take the chance of losing money, some people decide to do nothing. The thing that these folks sometimes miss is that when you do nothing, you also make a decision and that has risk too.
Are you taking too much or too little risk with your investing? How do you know?