The Basics
I had a weird question from an XM radio host the other day. She knew almost nothing about retirement investing, and was wondering why you should invest in stocks at all, since they pose some risk. Actually, that’s not a weird question for a novice, and deserves a longer answer than I had time to give her on the program.
Clearly, you can lose money investing in stocks, bonds, and mutual funds. This raises an essential investing question: How much risk can you take? Investors range from ultra conservative—you can’t bear the thought of ever losing a single dollar you save for retirement—to ultra aggressive—you’re okay with the risk of losing your principal for the possibility of huge gains.
When you invest in the market, you take the chance that your money might not grow as you had hoped, or worse, you could lose your principal. In its best year ever, the S&P 500 skyrocketed nearly 54 percent; in its worst year, it dropped about 43 percent, according to Ibottson Research. However, “in the history of the stock market, there is not one investor, who has left their money in the market for more than 20 years, who lost any money,” according to the National Endowment for Financial Education.
Nobody knows what’s going to happen in the future, but studies based on the past performance S&P 500 have found since 1925, the chance of losing money over one year is 28 percent; over five years, 10 percent; over 10 years, 3 percent; and over 20 years, zero percent.
And consider this little factoid from Jeremy Siegel, a Wharton School professor of finance who directs the Securities Industry Association Institute: For every rolling five-year investing period from 1802 to 2002 (that means 1802 to 1807, 1803 to 1808, 1804 to 1809, etc.), stocks have outperformed bonds 80 percent of the time.
In other words, the most important factor in deciding how much risk to take with a particular investment is your time frame. The more time you have, the more risk you can afford to take, because your investment has the opportunity to ride out the market’s ups and downs.
For example, we put 100 percent of my five-year-old’s college fund in stock mutual funds and individual stocks, because we won’t need to tap the money for 14 years. In 9 years, when she starts high school, we’ll shift her college money into a more conservative mutual fund, because at that point we don’t want the risk—we want “capital preservation”—to make sure the money is secure and available to cover the tuition bills. So we’ll settle for lower returns on the money in the final years before we need to spend it.
Identify your goal, put a time frame on it, and make a decision about risk: These are the essential first steps to successful investing.
Related Posts
