You’ll hear us talk a lot about “Investment Risk” at Financial Engines. That’s because it’s one of the most important aspects of your 401(k). Risk may not always be visible, but it is always there. It’s also one of the most difficult concepts for people to get their arms around.
What exactly is investment risk and how do you determine how much risk you’re comfortable taking in the first place?
Technically speaking, investment risk is the possibility that the return on your investment will be different than you were expecting.
It could be higher or lower than you expect, though most people worry about the downside more than they care about things going better than expected. Every investment carries some amount of investment risk, but some have more risk than others. Generally, investments in stocks have more risk than bonds. Some investments (like company stock, for example) carry a LOT more risk.
The truth is, selecting an appropriate risk level is one of the most challenging decisions you have to make with your 401(k). That’s because the amount of risk you’re comfortable holding is personal. Some people love the idea of doubling down and placing big bets on a single poker hand; others lie awake at night worried that they might lose some of their hard-earned cash in the process. Most of us are willing to put some money at risk in order to have a better chance of a good return. But how much?
Getting risk right.
One of the most important things to consider when selecting an appropriate risk level is how long you have until you retire (what investing professionals call your “time horizon”). According to Financial Engines research, only one third of 401(k) participants are doing it well; they have portfolios with an appropriate amount of risk given their time horizon. Another third have portfolios with inappropriately high risk levels, which can put their entire retirement savings in danger. Sadly, many people don’t know how much risk they actually have in their accounts.
Generally, younger people can afford to take more risk because they have time on their side and can typically make up for losses incurred during their early investing years. If things don’t go well early on in their careers, they can usually work a little longer to make up the difference. Also, with a longer time frame, investments in riskier assets like stocks are more likely to outperform a more conservative strategy.
Older participants don’t have the luxury of time. If the market tanks, they may have few options for recouping their losses. As a result, peoples’ tolerance for investment risk tends to go down as they age. For example, a 25 year-old may have a portfolio that consists primarily of equities (funds that invest in stocks), while a 65-year old may have the majority of their portfolio in less-risky bonds. If you can’t imagine the idea of losing money, you want to limit your allocation to riskier investments like stocks.
Stocks may be more likely to do better over the long run, but as recent history shows, you can lose significant money in the short term if the market doesn’t cooperate. And always be careful of putting too much of your nest egg in your company’s stock. Diversified investments like mutual funds may not go bankrupt, but companies can. Don’t make the painful mistake of losing all your retirement money at the same time you lose your job. It’s not worth the risk.
Only you can determine how much risk you’re comfortable taking. Whatever risk level you choose, you’re going to have to live with your choices. That may sound parental, but ignoring 401(k) risk (just like ignoring your parents’ advice) is just plain, well… risky.