It’s likely that you will need a lot of money to pay your expenses when you’re retired. Retirement experts say individuals should aim for a retirement income that’s around 70% to 80% of their preretirement salary. So, if you are saving for retirement, why would you put your retirement savings into investments that have the potential to lose money? Why would you even consider taking that risk as you near retirement? The answer is — for the potential returns. You want the assets in your savings account to at least keep pace with the inflation rate. And aiming for inflation-beating returns requires you to move out on the risk scale.
However, the big question is how far out on the risk scale should you go? You have to decide where to draw the line between risk and potential returns. That’s easier said than done. But there are a few steps you can take that will help you define that line.
Look at the Risk Scale
It is a given that the more risky an investment is, the greater its potential return. Different investment types — stocks, bonds, and cash equivalents — have their own specific risk and return characteristics. Cash equivalent investments generally present little risk of losing money. However, they usually deliver returns that may not be able to equal the inflation rate.
At the other end of the risk scale stand stocks and stock mutual funds. Stocks are more likely to suffer losses than either bonds or cash equivalents. At the same time, stocks have historically provided better long-term returns than the two other asset classes. More importantly, stock returns have outpaced the annual inflation rate over the long term. Since inflation can reduce your future buying power, you want to have some of your assets invested in inflation-beating investments.
Potential Versus Reality
If stocks have the potential to deliver the best results, why not put 100% of your retirement savings in stocks? Would that not be the simplest and most effective investment strategy? The reality is that this approach would be too risky. You want to structure your investment strategy in such a way that you can potentially reach your retirement goal with a manageable level of risk. Determining a manageable level of risk depends on your capacity for risk and the time you have available to invest.
Determining Your Capacity for Risk
Your capacity or your tolerance for risk is your ability to accept the possibility that your investments could fall in value in exchange for the possibility that they could earn higher returns. For example, could you handle a 10% drop in the value of your retirement portfolio without panicking? If the stock market declined 15% in one year, would you be forced to delay your retirement?
Your response to questions such as these can help you determine whether you are a conservative, moderate, or aggressive investor. Once you understand how much or how little investment risk you feel comfortable taking, you will be in a better position to allocate your investments in a way that aligns with your risk profile.
Your Investing Time Frame Is Important
Young investors can take on a higher level of investment risk because their portfolios have more time to recover from any temporary downturn in the stock market. Those investors who are close to retiring may choose not to take on too much risk with their investments since there might not be enough time for their investments to recover fully if they experience several losing quarters.
If your countdown to retirement is only a year or two away, you may opt to shift some of your money into less volatile investments, such as bonds and cash equivalent investments. That way, a downturn in stocks won’t have a huge impact on your retirement savings at the point when you’ll need to start drawing on them. Still, keeping a portion of your portfolio invested in stocks for their growth potential and their protection against inflation may make sense for you too.
Your financial professional can help you assess your tolerance for investment risk and work with you to see that your retirement plan portfolio is properly aligned with your goals and your risk tolerance. Contact the Trust Point team if you’d like to have a conversation and make a plan for your unique situation.