Saturday, September 27, 2008

The danger of inappropriate risk - part 2

I explained in the last post why taking on too little investment risk can endanger your retirement.  However, too much risk can also put your financial goals in jeopardy.

Because any stock investment can drop in value by 25% or more in any given year, you need to take on this risk carefully.  If your savings goals are many years from now, it makes sense to harness the power of the stock market's relatively high returns, even with the risk of losing a substantial amount of your investment.  However, as your savings deadline approaches, you should consider shifting into more conservative investments.  Here are a few factors that might help you determine whether you can afford to take on the risk of stock investments:
  1. Is your deadline flexible?  If you can afford to postpone retirement, a new house, or whatever your goal is for a few years in order to recover from market losses, then you can probably afford more risk.  If your goal is set in stone and you can't or don't want to adjust it, then you should probably invest in more stable investments as your deadline approaches.
  2. Is the amount of money you need for your goal flexible?  Perhaps your goal for retirement or buying a new house is not tied to very specific amount of money.  More is always better, buy you might find yourself in a situation where you would be able to weather a drop in the value of your investments and still meet your goal.  If so, you might decide that the possible higher return is worth the increased risk.
  3. How well funded are you?  Often you will find that the more money you have, the more risk you can afford to take.  If your retirement savings are pretty slim and you are living a fair modest lifestyle, you probably can not afford to take any risk that will lower your investment income.  However, if you have more than ample retirement funds and want to take on additional risk, you might very well decide that you are in a position to do just that.
  4. What is your general comfort level with risk?  This is tough to quantify.  However, some people genuinely would rather avoid greater risk even at the expense of almost certainly having less money in the end.  If this is how you feel after understanding what the cost of lower risk is, then it could be a good choice for you.
It is much easier to set up a portfolio for the future that contains the right mix of investments than it is to fix one that clearly had taken on too much risk.  If you have an investment portfolio that has lost money that you really could not afford to lose, figuring your way out of this situation is very difficult.  One the one hand, you have already lost more than you are comfortable with and you don't want to lose any more.  On the other, you don't want to shift into conservative investments until you have recouped your loss.  What do you do?

It is hard to give generic advice in this situation.  Every situation is different and there is not always one correct answer.  However, when I was a professional financial advisor, in most situations like this, I did give the same advice.  It is very difficult to cut your losses and shift to a more conservative portfolio.  If your investments are exposing you to more risk than you can withstand, you need to eliminate that risk - the sooner the better.

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