Monday, August 26, 2013

Risk & Return: Talk About a Complex Relationship! Part II

Imagine you have come to the office of Stoffer Wealth Advisors for a consultation. You need some help in reviewing and structuring your investments. You are concerned about securing a good rate of return on your investments and want to understand what will be the best approach. Here’s the rest of the conversation. Part I can be found here.

I’d like my portfolio to earn about 15 percent per year for the next ten years until I retire. Does that sound reasonable?

My first response is that it is an unrealistic expectation. A portfolio constructed to earn such a high level of return would have to be in the most risky investments. You would have to be prepared to stomach wild swings in the value of your portfolio. Even though the expected returns are higher, you could end up losing money, if you were forced to sell at an inopportune time. If you anticipate that a return of 15 percent a year would allow you to reach your target portfolio of $1,000,000, due to the high level of risk, you could end up with just $600,000, a far cry from your goal. Risk plays a key role in returns and is something each investor needs to factor into his or her plans.

So, if I don’t want to take more risk, what does this mean for retirement planning?
If you are like many people, you want to make steady progress toward your goals. It may take longer to reach them, but you prefer a less risky approach. You have worked hard to accumulate your assets and therefore you place a great value on preserving them. This assessment suggests it will be appropriate for you to begin saving and investing early on to allow time for your investments to compound. 

Added savings each year can make a big difference. Let’s say your portfolio grows 10 percent in a year you also added 10 percent in savings; your portfolio increases 20 percent in value. 

Finally, your age and time horizon are very important factors in understanding the equation of your expected returns. As you get closer to retirement, you have accumulated some assets. It is inadvisable to continue taking as much risk as you may have taken in earlier years. The pain of potential losses and the possibility of falling well short of your goals pose a level of risk that is just too great.

After I’ve retired I will no longer be saving. And I should be more conservative. So I might have an expected return of only five to six percent?
That’s right. Which makes it all the more imperative to have an investment mix that suits your capacity for risk while meeting your spending needs. You want to feel confident that you can stick to your plan, because getting nervous and bailing out of your risky investments during a market downturn usually results in poor returns. Also consider that you want an investment mix that minimizes the chance that you run out of money. You can see now that risk and return go hand in hand.

Yes, thank you. 
Thank you for asking good questions!

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