Sometimes, you have to embrace risk in order to reach your goals. When you can eliminate risk and still get where you want to go, however, you have the best of both worlds.
When it comes to saving for retirement, investors face many different types of risk. Will you have enough money to support yourself when you're no longer working? Will your investments perform well enough? Will you have unexpected expenses that eat up your entire nest egg? Combined with all the challenges investors face in their daily lives, it's not surprising that many people don't bother to prepare for retirement at all.
You can't eliminate all of these risks. But when markets perform well -- as they have over the past several years -- you may have an opportunity to reduce one important risk all investors have to deal with.
Have a flexible plan
When you first start saving for retirement, it's good to have a general goal. For instance, if you're looking to make your first million before you retire, it'll take you most of your career -- 35.5 years -- if you can set aside $250 each month and earn 10% on your investments.
But you need to realize that having a goal and a plan to get there is just a starting point. The assumptions you make will inevitably be wrong. Some months you'll save $500, and others you won't save at all. And the odds of getting exactly a 10% return over decades are just about zero. There are plenty of stocks that have had higher returns, even over long periods of time:
|
Stock |
10-Year Average Return |
|---|---|
|
ExxonMobil (NYSE:XOM) |
12.9% |
|
Altria (NYSE:MO) |
12.8% |
|
Caterpillar (NYSE:CAT) |
12.6% |
|
Costco (NASDAQ:COST) |
12.5% |
|
Deere & Co. (NYSE:DE) |
11.4% |
And even if you stick with broad-based investments like index funds, you still probably won't hit that 10% mark exactly. Historically, 20-year annualized returns on the S&P 500 have been as high as 13.85% and as low as 0.29%.
Adjusting to great returns
If you make excellent stock picks -- or just happen to hit a favorable period for the market -- you may find yourself ahead of schedule. That's where you have the opportunity to reduce your risk.
For instance, say you've put aside that $250 diligently each month for 20 years, but instead of 10%, you managed to get a 14% return. That would mean you've got almost $330,000 banked toward your retirement. And with another 15-plus years to go, you no longer have to make 10% each year to get to a million -- you'd need less than 7.5%.
That would give you the opportunity to cut risk by moving some of your money into safer investments like bonds. With Treasury bonds paying about 5%, a 50/50 allocation of stocks and bonds would probably get you close to that 7.5% return -- with a lot less risk.
Don't get greedy
Unfortunately, many people simply keep riding their gains, adjusting their goals upward. They might conclude that if they keep earning 14%, they'll have $3 million instead of $1 million when they retire. It's exactly that thinking that snared many near-retirees at the market top in 2000.
In retirement investing, having a target in mind lets you adjust your risk to match how the financial markets behave. By reducing your risk after having above-average performance, you can often reduce the impact of subsequent market drops without endangering your retirement.
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