Wednesday, September 24, 2008

The danger of inappropriate risk - part 1

The stock market's wild swings up and down are making daily headlines.  The government is putting together a massive 700 billion dollar program to prevent our entire financial system from collapsing.  Large, well-respected companies are going under or being bailed out.  This seems like a good time to talk about risk.

During times like these, many people become scared of the stock markets and hesitant to make investments.  Although you can save for retirement without using stock-based investments, it will be tough and you run a much increased risk that you will not save enough.

In the long run, government bonds - which are very safe investments - return an average of 3.7% per year.  The S&P 500 - a very broad index of 500 companies and a good measurement for the stock market in general - has a long term rate of return of 11.2%.  But, as you well know, if you invest in the stock market, you need to weather volatile times.

Suppose you are 25 years old, plan to retire at age 65, and have nothing saved for retirement.  You believe that you will live to the ripe old age of 95 and want to save enough to provide $50,000, adjusted for inflation, for every year of your retirement.

Let's examine the outcome of three different investment options:
  1. You can be very conservative and invest only in government bonds.
  2. You can choose a moderate portfolio of half stocks and half bonds.
  3. You can be aggressive and invest entirely in stocks until you retire when you will shift half of your money into bonds.
Assuming 2.5% inflation, rounding up to a 4% return on bonds and rounding down to an 11% return on stocks, you would need to save money at these rates in order to fund your retirement:
  1. Conservative: $1864/month
  2. Moderate: $554/month
  3. Aggressive: $232/month
There is certainly risk involved in investing in stocks.  They can drop dramatically in value.  If your investments drop in value just before your retirement, you could be facing big problems.  However, as the example above shows, most people cannot afford to invest enough if they are not investing in stocks.  Therefore, choosing investments that are too conservative dramatically reduces the odds that you will achieve your investment goal.

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