Chapter 14
IN THIS CHAPTER
Getting a handle on investing basics
Taking the plunge during a downturn
Recognizing risk
Realizing that risk and reward go hand in hand
Finding your risk tolerance
The whole reason you invest your money is so it can earn more money. Otherwise, you may as well just lock your savings up in a safe. (Of course, inflation would eat away at the value of your money while it sits in the safe. So investing your money is really your best bet.)
The bad news is that investing money involves a certain amount of risk. The good news is that you can use this risk to your advantage and score a higher return on your money.
Like many things, investment risk isn’t that scary after you understand it. This chapter explains the different types of risk involved with your 401(k) and IRA investments. The goal is not to frighten you away from investing but to make you comfortable by familiarizing you with the unfamiliar. After all, the key to successful long-term investing is building a good plan and sticking to it. Finding the level of investment risk that’s right for you will help you stick to your plan.
In general terms, investment risk refers to the fact that the value of your investment goes up and down over time. Another term often used to refer to the movement in an investment’s value is volatility. Essentially, the more volatile an investment is, the higher its risk.
In order to fully understand these concepts, you need to grasp some investment basics. If you’re already familiar with debt, equity, and the concept of diversification, feel free to skip down to the next section, which defines different types of investment risk.
Debt and equity instruments are the two types of investments you use to make money with your money.
When you invest in a debt instrument, such as a bank certificate of deposit (CD), you essentially loan money to an entity for an agreed-upon period of time. In return, you receive interest payments, and you get your principal (initial investment) back at the end of the term (maturity).
Debt instruments also include bonds and money market securities. They’re often referred to as fixed-income investments because the amount you earn is fixed and predetermined. The two main investment risks that you face with debt instruments are as follows:
Equity refers to the stock market. When you put your money in equity investments, you’re buying a piece of a company. The amount you gain or lose depends on how well or poorly the company does.
With equity investments, the main risk is that the company you invest in will do poorly or even go bankrupt. In the first case, the value of your investment goes down; in the second, you may lose all your money. On the other hand, if the company does phenomenally well, so does your investment. That’s why equities are generally considered more risky than fixed-income investments. However, the potential rewards (investment gains) of equities can be bigger than with fixed-income investments.
If a stock investment loses value, it’s often referred to as a negative return rather than a loss. Technically speaking, it’s not really a loss unless you sell the stock. If you hold onto the stock, its value may go back up over time, and you will have lost nothing. However, holding on to a stock and waiting for this to happen may be a bad idea, depending on the stock.
Mutual funds are a common investment option in retirement plans. When you invest in a mutual fund, your money is pooled together with that of many other people and invested under the direction of a professional money manager or in line with an index.
Mutual fund investments in your 401(k) may include the following broad categories:
Your 401(k) may also offer a stable value fund, which is a different type of fixed-income investment similar to a bond mutual fund.
I explain these types of investments (and more) in Chapter 13. For this chapter, what you need to know is that the different categories of funds carry different levels of investment risk and expected return. In general, money market funds are the least risky and historically have had the lowest return, while stock funds are the most risky and historically have had the highest return over long periods of time, such as 10 to 20 years. (Investing is all about trade-offs!)
Because of the large pool of investor money, mutual funds can invest in a number of different investment vehicles, which is known as diversification. Diversification benefits you by lowering your overall risk. (Read more in the “Diversifying for fun and safety” section later in this chapter.)
Participants often ask what return to expect on their 401(k) or IRA. That’s a great question, and I wish I could answer it definitively — but I can’t. Why? Because the return on your investments depends on a number of factors. I can provide guidelines based on past results of different investment types and generally accepted figures. These are long-term averages based on past performance; you can't assume that your investments will turn in exactly the same return or that they'll have the same return year in and year out, because they won’t. The return will fluctuate. For example, it’s reasonable to expect stocks to return an average of 9 percent over a period of about 20 years or more, but it’s not reasonable to assume that this will occur over shorter periods such as five years. Historically, stocks have periodically produced a much higher or much lower return during shorter time spans.
Investment returns over the long term, meaning 20 years or more, depend on the type of investment:
Because you’ll probably hold a combination of investments, the highest overall return for your account as a whole likely won’t exceed 7 percent — and it may be that high only if you’re holding at least 75 percent in stock investments. If your investment strategy is more conservative, you can reduce your expected return to 5 to 6 percent (even lower if you’re really conservative).
The best way to reduce your risk of loss, whether you invest in bonds, stocks, or other investments, is to diversify your investments — in other words, spread your money around. That way if one investment does badly, the others may do well and make up for the loss. Also, if one investment does extremely well, you’ll benefit.
Here’s an example of how it can pay off to put your money in a combination of different investments:
Manuel and Sophia both have $5,000 in their 401(k)s. Manuel chooses to invest his entire balance in a “safe,” stable value fund with an average return of 2.5 percent a year. Sophia decides to diversify her 401(k) money by investing $1,000 in each of five different categories. Her first investment choice fails, and she loses the entire $1,000 — a scenario that isn’t likely, but I use it to prove a point regarding the benefit of diversifying. Sophia’s second option doesn’t do well, and although she doesn’t lose any money, she doesn’t make any either. Her third, fourth, and fifth investment choices have average to above-average returns.
After 25 years, Manuel has $9,270 ($5,000 at 2.5 percent return for 25 years). Sophia, however, has $22,070. How did she do it? Table 14-1 shows the comparative returns.
TABLE 14-1 The Advantage of Diversifying Your Investments
Investing $5,000 as follows … | Results in … |
---|---|
$1,000 and loses it all | $0 |
$1,000 at 0% return | $1,000 |
$1,000 at 5% | $3,386 |
$1,000 at 8% | $6,849 |
$1,000 at 10% | $10,835 |
Total | $22,070 |
If Sophia had invested her entire account in the first option, she would’ve lost everything. By spreading her money over different investments, she overcame that loss and even ended up making more money than Manuel did.
It can be useful to own a mutual fund or ETF. Say you buy shares in a mutual fund that owns only stocks. The value of that fund can conceivably increase on a day that a single stock drops by 30 percent if the fund doesn’t own that stock. Even if your fund does own this particular stock, your account value may drop by only a few percentage points for the day — compared to 30 percent for a person who owns only this one stock.
It’s usually not enough to own just one mutual fund unless it is a TDF or similar fund that includes a broadly diversified range of stocks and bonds. I explain how to put together a good combination in Chapter 13.
It’s tempting to want to jump ship when stock prices take a downturn, but that is precisely what not to do. You also want to limit the times that you’re buying when prices are high. This section covers downturn opportunities and averaging buying low and high.
I remember telling the younger members of a group of 401(k) participants during the 2008 crisis that they should be celebrating because their chances for getting a 50 percent positive return during the next five years had become much better as they can buy many more fund shares at reduced prices. I encouraged them to keep investing as much as they can afford into the plan, which is what younger investors should do when there’s a major market downturn.
As one example of how investing during a downturn can pay off, Table 14-2 shows the result of an annual $1,000 investment on January 1 of each year in Vanguard’s 2040 target-date fund (TDF).
TABLE 14-2 Vanguard 2040 Target
Year | Annual Return Percentage | Annual Investment | End-of-Year Value |
---|---|---|---|
2008 | –35.11 | $1,000 | $649 |
2009 | 28.67 | $1,000 | $2,122 |
2010 | 15.33 | $1,000 | $3,601 |
2011 | –2.11 | $1,000 | $4,504 |
2012 | 15.58 | $1,000 | $6,362 |
2013 | 24.79 | $1,000 | $9,187 |
2014 | 7.61 | $1,000 | $10,962 |
2015 | –1.25 | $1,000 | $11,812 |
2016 | 8.98 | $1,000 | $13,963 |
2017 | 20.86 | $1,000 | $18,084 |
2018 | –7.23 | $1,000 | $17,697 |
2019 | 24.19 | $1,000 | $23,220 |
2020 | 16.31 | $1,000 | $28,170 |
In 2008, the fund lost more than 35 percent of its value, but the table shows that continuing to invest pays. If you still have years to invest, there’s no need to panic when big market drops occur.
When you invest a specified amount at regular intervals, as you do with automatic 401(k) contributions or automatic IRA deposits from your paycheck, you use an investment strategy called dollar cost averaging. (You didn’t know you were that smart, did you?) This investment strategy may lower the average price that you pay for your investments. How? Because you’re spending the same amount each time you invest, you end up buying more shares of your investments when prices are low and fewer shares when prices are high. By averaging high and low prices, you reduce the risk that you will buy more shares when prices are high.
Of course, if stock prices only go up for the entire time you invest, this strategy won’t work. But if you contribute to a retirement account over a long period of time, there will likely be periods when prices go down.
Continuing to invest new contributions when stock values drop also helps because you accrue new shares at a reduced price. Everyone likes buying things at a discount, which is what you can do when stock prices drop a lot.
Several types of risk come into play when you’re investing. The following sections explain what those types are, but keep in mind that this isn’t an exhaustive list of all kinds of risk.
No one wants to lose any money, but folks are especially fearful of losing more than they can afford. You probably won’t lose everything in your 401(k) account, but losing to the point of severe pain is a very real possibility (especially if you don’t diversify your investments).
If you’ll need your money in five years or less, however, you may not have time to recover from a drop in the stock market. This is when you need to move some of your money out of high-risk investments and into more stable investments that safeguard your principal, such as money market funds, stable value funds in a 401(k), and shorter-term bonds.
A common mistake 401(k) investors made during the late 1990s was putting too much into certain stocks that were doing extremely well such as computer and software producers instead of diversifying their investments. (They may have thought that they were diversifying by buying a high-tech mutual fund instead of stock in a single company, but that didn’t help when the entire industry bubble burst.) When those companies’ performance began to suffer, many portfolios lost a lot of value. After the dot-com bubble burst in 2000, younger investors picked themselves up, dusted themselves off, and started all over again with diversified portfolios. But investors within a few years of retiring had a completely different outlook. Many had to delay retirement.
The stock market slump that began in 2000, combined with the Wall Street collapse in 2008, caused many people to worry about losing all their retirement savings. Some workers want to know if they should pull their 401(k) money out of stocks and invest in something safer during such times.
Before you do something rash (such as pull all your 401(k) money out of stocks), you need to understand that there’s no such thing as a completely risk-free investment. Even if you bury your money or hide it in your mattress, your dog can still dig it up and eat it for lunch, or the money can be stolen. Even the investments most people consider completely safe — FDIC-insured bank savings accounts and certificates of deposit (CDs) — are only guaranteed to a certain point. They still carry some risk of loss.
A number of 401(k) investors face the very real risk of holding too much stock in their employer’s company. Company stock may be available in a number of ways:
The second point is very important. The fact that many companies prospered throughout the 1990s, and their stock values consistently increased, led a number of employees to invest some or all of their own contributions in company stock. Just how bad an idea this is became apparent in 2000, when the stock market began to decline and many investors lost big chunks of their retirement accounts. The old adage about not putting all your eggs in one basket can’t be more true.
Yes, it can be hard not to invest a lot in your own company. After all, you work there, and you want to support the company, as well as feel that you have an ownership stake in how well it does. What’s more, you may have gotten a big sales pitch from senior management on the benefits of owning company stock. Many senior managers want employees to own as much company stock as possible. Interesting psychology is at work here. According to at least one study, 401(k) plan participants who receive a matching contribution in company stock are more likely to also invest their own contributions in company stock if such an option is available in their plan. So, if your company matches your contribution in stock, you’re more likely to direct your own contributions into company stock, when really, the rules of diversification dictate that you should put your own contributions somewhere else.
Not to be ignored is the possibility that your buddies at work may laugh at you for investing your money in mutual funds when they’re making a ton of money investing in company stock. The pressure to not miss out on this “once-in-a-lifetime opportunity” can be great. One solution: Ignore your buddies.
If your employer gives you company stock, you certainly shouldn’t look a gift horse in the mouth. Take it! But think twice before you invest your own money in company stock. The risk of a major loss is simply too high. Many large, well-known companies watched their stock prices drop by more than 50 percent during the market downturn that began in 2000.
Unfortunately, many 401(k) investors with a lot of company stock learned this lesson the hard way, at the worst time — in their 50s and nearing retirement. For years they saw the value of their accounts grow as they rode the company stock rocket. Then, seemingly overnight, they watched much of what they had gained flame out and disappear.
A single stock has much more potential to move up and down than a diversified collection of investments. Keep your ownership of company stock at the lowest level permitted by your plan in order to avoid unnecessary risk. This type of risk is called company risk or unsystematic risk, and the only way to reduce or eliminate it is to diversify your investments.
Considering the risks outlined in the previous sections, you may wonder why investing your money in anything other than a relatively safe bank savings account is even necessary. The answer is that you need to beat inflation, the gradual rise in prices over time. You may be able to avoid many investment disasters, but inflation isn’t one of them.
If prices rise by an average of 3 percent a year, your money will lose more than 60 percent of its value over 30 years. This means that the $100,000 you have today will be worth only $40,000 when you need it at retirement 30 years from now. This loss is just as real as waking up tomorrow morning to find that your account value has dropped by 60 percent. Ouch!
When you think about it, retirement investing is a 40- to 60-year event that includes both your working and retirement years. You can’t afford to accept a safe return over this time period, because it may not keep up with inflation.
“Simple,” you may be saying. “All I have to do is invest in something risky, and that will bring up my average return.” Unfortunately, it’s not that easy. Although you generally have to take on more risk to get a higher return, or reward, that doesn’t mean that every high-risk investment will give you a high return. Some may fail miserably.
I explain general guidelines in Chapter 13. You can also hire a financial planner to do an analysis for you or use financial planning software and services available over the internet. A financial planner (or software) will run a number of different scenarios through the computer and come up with a combination of investments that should give the greatest potential return for a given level of risk. This would be nearly impossible to do on your own.
As an example of why it’s so important to try to get the best return possible at your desired risk level, Figure 14-1 shows the impact of an additional 3 percent return on your ending balance.
As the table shows, a 9 percent return results in an end balance of $273,000 after 30 years versus $158,000 at a 6 percent rate of return. The 3-percent-higher return generates a 73-percent-higher 401(k) nest egg and a 73-percent-higher retirement income. To achieve the same result over 30 years at the lower rate of return, you’d need to make an annual contribution of $3,460 instead of $2,000.
The key to managing risk is knowing how much you can tolerate. When you know how much risk you can handle, you can find investments that you can live with over the long term. If you panic and sell your investments following a price plummet, all you’ll do is lose money. If you can stick it out and not sell the investments when they’re low, you’ll be in better shape.
Can you handle drops of 20 percent, 30 percent, 40 percent, 50 percent, or even more in the value of your account? Answering questions like this helps you determine whether to invest in risky stocks or safer bonds. Imagine yourself with a retirement account of $100,000 that drops to $50,000 in value. Would you be able to hang on, or would you, like so many others, be tempted to sell those investments and put the money in lower-risk investments? If you sell, you’ll have to dramatically increase your contributions to make up both the loss and the lower investment return you’ll get in the future. Many investors are comfortable owning stocks when things are going well but tend to sell when stocks are down. This is generally the wrong thing to do.
Stocks have averaged an 8 to 10 percent return since 1926. Bonds have averaged a 4 to 6 percent return. These average returns are indicative of the broad stock and bond markets. Your average annual returns should have been in these ranges if you owned a broad range of stocks and bonds during this entire period and didn’t panic and sell out during bad years.
Being highly diversified means you own large-, mid-, and small-cap growth and value stocks. One way to do this is to invest in a TDF. A TDF, or Target Date Fund, is a mutual fund containing a diversified group of investments. It automatically adjusts the stock/bond ratio to become more conservative as you get closer to your retirement age. Table 14-3 illustrates the risk-reward trade-off. The numbers in the table are based on the assumption that stocks produce an average of 8 percent return and bonds an average 4 percent return over the long term of 20 years or more. Average returns over shorter periods will be much different, and the average returns also vary substantially depending on what stocks and bonds you own. Actual historical returns vary depending on the time period selected and the mix of stocks and bonds included in the averages.
The results vary substantially depending on the beginning and ending dates. A change of only one year can result in quite different average returns, particularly if the time period selected is only ten years. The same is true depending on what mix of stocks and bonds are included in the results. This is why I am using 8 and 4 percent average returns because they are indicative of what can be expected over longer periods of time — 20 years or more.
In Table 14-3, the first column indicates the stock/bond ratio. The second column is the expected average annual return over a period of 20 years or longer. The worst and best years are based on historical results during the past 20 years. No one has any idea when the worst and best years will occur over the next 20 years, which is one of the things that makes investing so difficult.
TABLE 14-3 Sample Historical Average Investment Returns
Bond/Stock Ratio | Average Return | Worst Year | Best Year |
---|---|---|---|
100%/0% | 4.0% | –8.1% | 32.6% |
70%/30% | 5.2% | –14.2% | 28.4% |
50%/50% | 6.0% | –22.5% | 32.3% |
0%/100% | 8.0% | –43.1% | 54.2% |
Some investors focus only on the average annual return when deciding how to invest. Others may focus on what’s currently hot — the fund that had the highest return during the past year. Those who focus on the highest average annual return may be tempted to invest 100 percent in stocks because they have the highest average annual return. They are very content when things are going well; however, they may panic and cash out when their accounts drop by 30 or 40 percent. That is why you must consider how well you will handle a major drop in value.
Those who chase what is currently hot run the risk of getting hammered when that market segment drops out of favor and becomes very cold. This is what happened with tech and internet stocks during the 2000 dot-com bubble. The same potential exists today for tech stocks and cryptocurrencies.
The stock market is at an all-time high as I write this. It is highly unlikely from a historical perspective that 2022 will be the year that produces the highest return during the next 20 years. The same is true for bonds because bond prices decline when interest rates rise. At the same time, inflationary pressures are increasing. Interest rates historically increase during inflationary times. As a result, 2022 also isn’t likely to be the year that produces the highest return on bonds during the next 20 years.
Long-term investing gives you a lot of time to recover from market slumps. The important thing is to choose good, solid investments and reduce your stock holdings as you approach retirement, when you’ll have to start generating an income from your investments. (Within your stock investments, you can also shift from growth stocks toward value stocks, which tend to be less volatile.)