The Three Keys to Successful Retirement Investing, Part 2

As stated in the last post, successful investing in retirement really comes down to fundamental principles more than finding the right mutual fund. Utilize these principles to drive your decisions and you'll be successful. I'll call these the Three keys to retirement investing. These are:

1. Contribute early and regularly
2. Take appropriate risks
3. Delay withdrawals as long as possible

In this series of posts, we'll look at each of these keys and why they are important. Today we'll look the second key, how to take risks appropriate for you investment horizon and personal risk tolerance.

Key #2: Take appropriate risks

The first aspect of investment risk is volatility. Let's start there.

Volatility

Most of the time when people talk about investment risk, they are talking about volatility. This is how rapidly the value of your investment changes. In other words, how much of your money you can lose in a relatively short period of time. Things that are volatile like individual stocks can go up or down in price by 50% easily within a year, and can sometimes do so within a period of a few days or weeks. In fact, stocks tend to make fast moves in one direction or another as news breaks, followed by a period where they change in price little.

Volatility is often measured by the term, beta, which can be thought of as the volatility of an investment compared to the whole market. Stocks that have a beta of 1.0 have a volatility level equal to that of the market. Those with a beta of 2.0 have twice the volatility of the market. High beta stocks move up and down more than low beta stocks.

Investments that are more volatile are considered to carry more risk than those that are less volatile because their return is less predictable. If you put $100 in a bank CD yielding 1% per year, you'll know that it will be worth $101 in a year. If you invest $100 in a stock index fund, it might be worth $140 in a year, or $60 in a year, or anything in between. Stocks are very volatile when compared to bank CDs. Because volatile investments have more risk, you want to only buy them if your potential for reward is greater. If you can get an assured 1% in a bank CD, why would you buy a stick if the potential return were the same? Maybe you would want to get a 50% gain from an individual stock when things work out to make up for the times when they don't. Let's say that four times out of five your return is 0%, where it is 50% the other time. By buying many stocks, you can then nearly assure yourself of getting an average 10% return overall if you can get a 50% gain when things go your way. If the gain in stocks was only 5% when successful, you would be making the same return as you could with the bank, so it would not be worth the risk.

The return you receive is based on the price you pay when you invest. If you're buying an individual stock, you need to pay a low enough price so that when earnings come in and meet expectations, the value of the stock will move up enough to give you the 50% return you desire (just to use the numbers we've been using). Luckily for you, while there are some random fluctuations in price, on average stocks (and other investments) will already be priced appropriately for their risk levels due to the behavior of the market. If you buy at several different times, as opposed to simply dumping your money in all at once, the random fluctuations will smooth themselves out and you'll pay a price that is appropriate for the risk. Over long periods of time, the average return on a portfolio containing a large number of stocks has ranged from about 10 to 15% per year. This is significantly better than the returns of bonds (which range from 5-10%) and bank investments (which range from 0-5%).

So in summary, higher volatility leads to higher returns, but high volatility can also cause losses. The trick is to use two other factors, diversification and time, to manage that risk and make it so that you are almost guaranteed to make a great return. Let's look at each of those aspects.

Diversification

Diversification, where you invest in more than one thing, reduces volatility risk. If five stocks are moving randomly, if you buy shares in all five the movements up in some will cancel out the movements down in the others most of the time since the movements are random. This is the same as throwing a hand full of coins - you don't know which ones will be heads and which will be tails, but you know that the result will be somewhere between 30 and 70% heads a lot more often than it will be between 90 and 100% heads or 90 to 100% tails simply because there are a lot more combinations in the 30-70% heads range than there are at either extreme. Because the average price for stocks has a natural tendency to increase (because companies become more efficient and grow, and make more money), if you buy a group of stocks the random fluctuations in the value of the group will cancel but the overall average value will increase.

The other form of risk that diversification eliminates is the risk of bad management or random events. If you just buy Coke stock and the Coke CEO makes a bad decision (like introducing New Coke in the 1980's), you could see the value of your investment crater even though people are still drinking soft drinks and cola stocks, in general, are doing well. If you buy stock in both Coke and Pepsi, however, while one of the companies may make a bad decision and cause their stock to drop significantly, it is unlikely that both will do so at the same time. In fact, a misstep by one might provide an opportunity for the other. It is even better if you buy shares in different industries since then you eliminate the risk of a downturn in a specific industry. If you buy Coke and Pepsi, plus shares in a bank, and shares in a medical device supplier, while one industry may go through a rough patch where all of the companies in that industry decline, it is unlikely that three different industries would hit trouble at the same time.

It is even better if you buy shares in different industries since then you eliminate the risk of a downturn in a specific industry. If you buy Coke and Pepsi, plus shares in a bank, and shares in a medical device supplier, while one industry may go through a rough patch where all of the companies in that industry decline, it is unlikely that three different industries would hit trouble at the same time. The easiest way to add diversification is to buy mutual funds, index funds, or ETFs, all of which allow you to make one investment but get investments in a large number of assets. If you buy shares in an S&P500 index fund, for example, you'll be invested in 500 large US companies. but at a cost far lower than it would be to actually buy shares in all 500 companies. In 401k accounts, mutual funds and index funds are normally the only choices.

There will also be times when an entire market declines. For example, investors may be worried about an election and decide to sell their shares in US stocks. In this case, shares of all US stocks may decline - both the good and the bad. Note this is really the time to buy more shares since they are effectively on sale, but if you have money invested that you need soon, you may not be able to wait for prices to recover. To guard against this risk, you can diversify into more than one type of asset. For example, buying both stocks and bonds, or buying both US and international stocks. In general, you try to find investments that aren't tied to each other so that they don't move together. This can be difficult, but having investments in stocks, bonds, and REITs is not a bad combination, in part because the interest payments and rental income paid by bonds and REITs, respectively, help to keep them from declining in price as much as stocks when the market declines. Of course, for short-term needs (like within five years), cash is the appropriate investment.

Time frame is often forgotten when looking at risk. Time frame will also reduce risk since you don't need to be right about the timing for an investment to do well if you have a lot of time to wait, you just need to wait until things start to happen. If you have a lot of time, you can reduce your diversification (but not eliminate it since single stocks or bonds can disappear entirely), since you can just wait out a market downturn or wait for the product lines of the companies you're investing in to catch on. In general:

Risk is proportional to: (volatility)/(diversification x time)

More volatility causes more risk, but time and diversification both reduce risk. In addition to reducing risk, however, diversification reduces your reward potential. When looking at buying single stocks, adding more investments means some won't perform as well as others. If you just buy Coke and Coke increases in share price by 100%, you'll do better than if you buy both Coke and Pepsi and Coke goes up 100% but Pepsi only goes up by 10% over the same period. Diversifying into other markets also reduces your potential reward. Because lower volatility investments like bonds don't provide the same long-term return as higher volatility investments like stocks, diversifying into bonds will reduce the level of fluctuations in your overall portfolio value but also reduce your long-term return.

It is, therefore, better to use time to reduce risk than diversification if you have time available. If you can stay invested for a long period of time and can just wait out market declines, it is better to hold more stocks than bonds. As you get closer to needing the money, you then add diversification closer to equal percentages of growth investments like stocks and income investments like bonds to reduce risk since you no longer have the luxury of time.

Using appropriate risk

So to use appropriate risk when investing in a retirement account, do the following:

1. When you don't need the money for a long period of time (like 20 years), concentrate more in higher volatility assets like stocks since they have a higher return. A rule-of-thumb is to put your age minus 10% in income assets like bonds and the rest in growth assets like stocks.
2. If volatility scares you, add more income assets that will reduce volatility (and don't look at your portfolio value too often - a couple of times per year is fine).
3. When you start to get close to the time when you'll need the money, add lower volatility assets like bonds and REITs that pay out cash and have a more stability.
4. Assume that your stocks may be up or down 20% in five years (and 50% in one year) and that your bonds may be up or down 10% in five years (and 15% in one year) and decide if you can take that risk. For money you really, really need to have within five years, go to cash assets like bank CDs and money market funds since those are the only things that don't go down in value.

Got an investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.