Economists talk about risk differently than the rest of us. They use words like "systemic" and "systematic." They differentiate market risk from liquidity risk from reinvestment risk. But as a layperson who's carefully setting money aside to retire, you probably think about risk in more concrete terms -- like, the risk of losing money or the risk of making unsound investment decisions.
Here is a closer look at four real-world risks you might experience as a novice investor, and how to manage them.
1. Your securities could lose value when you need to liquidate
At some point, your investments will lose value. You should get comfortable with that idea because there's no stopping the rise and fall of stock prices.
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It helps to remember that the value of your investments is of primary importance on the day you need to liquidate. Twenty years before you liquidate, a dip in your stock's value is often a nonfactor. Say a stock you own loses 10% of its value tomorrow. If the drop is prompted by a temporary circumstance, then your stock should rebound. If you wait for that rebound and later sell the stock at a sizable profit, the prior value loss becomes irrelevant.
The other outcome to that scenario isn't as rosy. Say the stock drops 10% tomorrow and you just retired. You may have to sell that stock at a loss to fund your retirement distributions. Here, the loss in value is relevant.
There are two ways to protect yourself from selling at a loss after a stock market dip:
- Keep a nice sum of emergency cash on hand. Plan on a balance that can pay your expenses for three to six months, or more if you're nearing retirement. This gives you a cash cushion to use before you start liquidating stocks.
- Don't invest money you expect to use in the next five years. Then you should have time to ride out any market volatility.
2. Your portfolio could underperform over time
Seasoned investors focus on long-term performance. This is because market behavior in the short term can be unpredictable. The challenge is that long-term performance is hard to gauge from year to year. There is the possibility you'll realize 15 years into your savings plan that you're way behind where you should be. That can generate panic or, worse, force you to delay your retirement timeline.
Three strategies can help you avoid feeling disappointed with your long-term investment performance:
- Have realistic growth expectations. The long-term average growth rate of the stock market is about 7% after inflation. If you have an equity-heavy portfolio, use 7% as a benchmark. If you have less equity exposure, plan on a lower growth rate.
- Follow best practices for asset allocation by age. A guideline for the percentage of stock you should own is 110 minus your age. Using this guideline at age 45, for example, your portfolio would be 65% stocks and 35% bonds and cash. This strategy allows for growth without too much risk.
- Compare your portfolio's performance to market behavior at least once annually. If the market falls 15% one year, you're not going to see growth in your retirement account. But if the market goes up 15% and your account loses value, then you are underperforming and it may be time to make a change.
3. You could get overconfident
In strong markets, many investors get overconfident. Overconfidence can easily lure you into investing more than you should, making quick buy decisions, and chasing short-term gains.
The thing is, the stock market can quickly shift from strong to weak. When that happens, overconfident investors can get hit the hardest. They can end up over-extended and holding unnecessary losses in their portfolios. Worse, those losses can be on stocks that don't have long-term potential -- stocks they bought to turn a quick profit.
Staying grounded as an investor starts with having a clear sense of your investing approach. Your approach encompasses your goals, your timeline, how often you trade, and the stocks you like to own. Once you define those parameters, you can recheck your rationale for every transaction. Ask yourself if the trade fits your plan. If it doesn't, move on and don't look back.
4. You could lose confidence
Too little confidence can be as damaging to your wealth as too much confidence. In down markets, you need to believe that a recovery will follow. Without that confidence, you may liquidate everything and hide out in cash. That's usually the wrong move.
To keep your confidence intact, research the stock market's history of recoveries. In the past century, investors have faced a Great Depression, a Great Recession, an oil crisis, stagflation, a technology bubble, a pandemic, and more. Every time, the market has recovered. Believe that pattern will continue and it'll be easier to keep a clear head when the next big crisis hits.
Facing risk
Investing in the stock market comes with risk. You can't avoid risk, but you can face it and manage it. Keeping cash on hand, tracking your performance versus the market, sticking to your investing plan, and believing in the high likelihood of recovery are four risk management tactics any investor can pick up.
Use these practical strategies as protection against a liquidity crunch, a dud portfolio, and the mistakes that come from too much or too little confidence. And, as a bonus, you can chat about your approach at cocktail parties without sounding like an economist.
