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A Tricky Balance: The Risks and Rewards of Investing

By on September 23, 2020
Categories: INVESTING, RETIREMENT

A variety of reasons exist to invest.

People invest to…

  • Retire
  • Purchase a home
  • Purchase a vacation home or rental property
  • Pay for education

Investing platforms make the actual practice of investing quite easy. It’s simple to invest electronically and to invest automatically.

What is far more difficult is knowing what to invest in. It’s important to get this piece right if you want to reach your financial goals. While an experienced financial planner can help you through this decision process, below are some things to consider.

Balancing Risk and Rewards

Here is an example:

Let’s say an individual’s goal is to retire at age 65 (at which time, he or she will be eligible for Medicare). If the individual’s assumed life expectancy is roughly 85 years old, he or she would need 20 years of income to replace current wages (not only to fulfill basic needs, but to continue enjoying a desirable lifestyle).

Research tells us that individuals need to replace approximately 80% of the income they made while working for their spending needs in retirement. Social Security, however, only replaces about 40% of pre-retirement earnings, or only half of what they’re going to need*.

After tapping into Social Security, the rest of what that individual will require in retirement will need to come from their savings.

The question then becomes, “Is saving in a deposit account (e.g., a checking and/or savings account) sufficient to build enough wealth for retirement?”

Right now, you would be lucky to receive 0.05% of interest from a savings account. If inflation is two percent per year, you would be losing ground because the savings rate of return is not keeping up with the increase in prices of goods and services over time. In other words, your purchasing power is declining.

To overcome inflation, people invest in assets such as stocks and bonds to generate a higher rate of return.

Ultimately, you need to determine what your ideal asset allocation (or mix) of stocks and bonds is to help them meet your financial goals.

To determine what that ideal asset allocation is, you need to first understand the direct relationship between risk and reward. The lower the risk taken with your investments, the lower the potential rate of return. To obtain a higher potential return, you need to take on more risk.

Overall, stocks generate a higher return (with a higher level of risk), which is appropriate for long-term investing. In contrast, bonds (particularly short-term bonds) generally carry relatively less risk and, consequently, offer a lower expected rate of return.

The shorter the investment horizon, the less risk an investor should generally take. For instance, if a young couple wants to save for a down payment for a house, they will likely invest in bonds because they will need to access cash in a relatively short amount of time.

Conversely, if a young couple is saving for retirement, they can afford to take on more risk (through assets such as stocks) because they will not need the money for decades. They can ride the ups and downs of the stock market as they continue to contribute to their retirement accounts over time.

At the end of the day, your asset allocation should take into consideration the risks and rewards they are able and willing to take on to achieve their financial goals.

Footnotes:
*Assumes a household pre-retirement income of $100,000 per year. Household income replacement rates are derived from an inflation-adjusted analysis of Consumer Expenditure Survey (BLS) data (2013-2016)and Social Security benefits using modified scaled earnings in 2019 for a single wage earner at age 65 and a spousal benefit at age 62 reduced by Medicare Part B premiums. The income replacement needs may be lower for households in which both spouses are working, and the second spouse’s individual benefits are greater than their spousal benefit. Single household income replacement needs may vary as spending is typically less than a two-spouse household; however, the loss of the Social Security spousal benefit may offset the spending reduction.

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