The market has taken us on a wild ride over the last few years. This has caused some investors to question whether they should even be in the market. After all, we do not invest to lose money. We expect to see a profit from our investments. The reality is sometimes the markets are up and sometimes they are down.
Generally there is a relationship between risk and return. The more risk someone is willing to take, the more potential return. This is not a guaranteed return. It just means if there is a return, it could be higher than someone taking less risk. It also means losses can be larger.
You may ask, “Why risk my money if I can get a guaranteed return?” Let’s consider a hypothetical situation involving two young people, Bob and Sally, starting their careers.
Both start working on January 2, 2012 at age 25. Each decides to retire at 65. Each makes $65K/year and each signs up for the company 401(k) plan.
Bob decides to be safe and not lose money. Even though interest rates are low now, he believes he can average 2% return on the money market fund in his 401(k). Some years he may get more, some years less, but he believes he will always make something. He starts contributing $600/month towards his retirement.
Sally considers a different approach. She understands that if she takes some prudent risk, sometimes her account balance will go down when there are losses. However, she figures if she continues to put money aside especially during the down times, it will be an opportunity to “buy low.” She also starts contributing $600/mo towards her retirement. She chooses a mix of funds, or “diversifies her portfolio,” to manage her risk. While she thinks she can make an average 8% return on her money, she decides to plan on 7%, and make changes later if needed.
Let’s fast forward to their retirement. Bob is happy. Over the years he never lost a dime. He now has a nest egg of $441K. Sally, on the other hand, stayed diversified and rode the market ups and downs. As she approached retirement, she made her portfolio more conservative, to reduce her overall risk, but remained diversified. She ended with a nest egg of $1.575Million.
When Bob and Sally start their retirement we see another difference. If inflation averaged 2.5%, the initial $65K lifestyle will now cost $175K in the first year of retirement and climb to $253K/ year in the 15th year of retirement. While Bob never “lost” money, he faces a bigger challenge in retirement. He will need to drastically reduce his expenses or risk running out of money. Sally, however, will have a more flexible lifestyle.
Whether you are starting out, many rears retired, or somewhere in-between, there is a strategy that could help you reach your goals. Work with someone you trust to help you develop a course of action you can feel comfortable implementing.