Most of us “want more” in life. Whether that’s more time, more experiences, or most commonly, more money. We may not often consciously think of it in this manner, but there is a consequence, opportunity cost, or sacrifice we make when we aim to achieve “more.” Often times, the more we want something, the bigger the sacrifice required to obtain it. Investing is no different when it comes to the risks that we must take in order to achieve a desired outcome.
Risk exists every time one invests their hard-earned retirement savings, and your tolerance for risk is typically determined by your ability to handle the emotional consequences when (inevitably) things are temporarily not going your way.
If you define yourself as someone who cannot emotionally accept the risk of losing money (even if it is temporary), then Certificates of Deposit (CD’s), U.S. Treasury Bonds, money market or savings accounts might make more sense. However, it should go without saying that with less risk comes much lower reward, and the more time the passes, the bigger the dispersion between “risky” investments and those that carry smaller perceived risk.
But what if I told you that there is a big risk you take when you “play it safe?” It’s a little thing called Purchasing Power Risk (or Inflation Risk), which is defined as the risk that your money won’t be able to buy as much in the future as it does today, as a result of the constant increase of the cost of goods/services (due to inflation). To make matters worse, when you consider the effects of Purchasing Power Risk and then add-in the cost of tax paid on your returns, the the risks get even higher and the payout, even lower.
If you consider yourself to be more risk-tolerant, then you might have the emotional wherewithal to own riskier investments, which provide a higher opportunity to earn more money over time (and again, the more time the passes, the bigger the reward).
Humans are very interesting when it comes to the behavioral psychology of money and risk. Studies have proven that the measured “joy of winning” (making more money) is much lower than the measured level of “emotional pain” when you lose money. For example, the data suggests that individuals “feel” the pain of losing 10% more than they feel the joy of gaining 10%, and this takes us right back to our discussion on risk vs reward.
Think about this for a second… If I said you could participate in a game where you had a 1/5 chance to win a $100,000 with no downside (you either win or you don’t), everyone would play. Now, if I switched the game and said you had a 1/5 chances of owing $100,000, your perspective immediately changes.
When the market is going up with little pull-backs or volatility, human psychology shifts to a mind-state that is naturally more aggressive, because they want more growth when the going is good. Of course, it’s easy to forget the risk associated with more aggressive investing when the market is healthy, especially when you haven’t felt the pain of downside market pressure in awhile. Now, can you guess what happens when the market behaves in an erratic and volatile fashion and investors experience short-term drawdowns in their retirement portfolios? Yep… they become instantly more conservative.
Simply put, the risk vs. reward tradeoff is the concept that, as you take more risk, you deserve more return over time. When it comes to an investment or retirement portfolio, there are many factors that play into the risk an investor should take (age, years to retirement, goals, etc.), but if you’re taking so much risk that you can’t sleep at night and you feel you’re developing an ulcer every time you look at your portfolio, then something may need to change.
One of the biggest road blocks between an investor and their retirement goals is that person’s ability to stick with their investment plan. Said another way, our genetic makeup has made us our own worst enemy, so be sure you understand the amount of sacrifice and risk that comes with your desire to make more!
Til Next Time,
ZakCategories: Educational Articles, Zak Leedom