When constructing a portfolio, a frequent goal is to obtain the greatest long-term returns with the least amount of risk. The only problem is that these two goals often contradict each other.
When investing, you receive returns because of the inherent risk involved. Generally speaking, the riskier an investment, the greater the potential returns—but also the greater the potential for losses. Conversely, the more conservative an investment is, the lower long-term gains an investor should expect, although the chances the investor’s principle will be protected are higher.
When reviewing your asset allocation, how do you know how much risk you should be taking on? What rate of return do you need during your working years in order to have enough saved to finance the retirement of your dreams? How do you calculate what your needed rate of return is to maintain your lifestyle upon reaching retirement?
Two Key Factors
The answer, as it so often is when discussing financial planning, is “It depends.” The key to finding an answer to this question rests primarily on two key variables: your goals and your time horizon. Is your goal to retire as early as possible? If so, you may need a higher rate of return during your working years and a more aggressive allocation.
On the other hand, if you want to work as long as possible—and possibly continue working part-time in retirement—then you may not need to take on as much risk. And if you have savings goals beyond just retirement, such as saving for your children’s or grandchildren’s college education, they will further dictate what rate of return you may need to seek from your portfolio.
In regards to time horizon, the sooner you’ll need the money you’re investing, the less risk that money should be exposed to. If you’re holding short-term money in stocks, you’re much more susceptible to having to sell those securities during a downswing in the markets. If you won’t need the money for several years, then you may be able to afford to take on more risk.
You can also take the pillow test to evaluate whether you’ve taken on too much risk. Ask yourself: If the market falls 5% tomorrow, will you still be able to sleep easy? If you know that the portion of your portfolio in equities is long-term money (money you won’t need for 10-15 years), then this answer should be yes. If the answer to that question is no, then it’s possible you have too much exposure to the stock market; a comprehensive financial plan may help you avoid being perpetually stressed out about your money.
Any investor would love to capture all of the upside of the markets while avoiding the times when the market falls. In reality, that investment doesn’t exist. Instead, reflect on your goals to evaluate how much risk you really need to take on in order to obtain your needed rate of return.
This article originally appeared on October 4, 2015 in the Des Moines Register. You may view the article here.