Investment risk: needs vs. wants
June 27, 2014 by Editor, InvestingForMe
When working with clients I have always approached investing their hard-earned savings with this question in mind – Do they need to take investment risks or do they want to take investment risks? In much of today’s investing world, however, investors are very rarely asked how much investment risk they need to take with their savings. Instead many of today’s investment pros are much more interested in how much investment risk you can tolerate, or how much do you want.
Usually they or their questionnaires ask you how much would your investment have to lose before you’d start to panic, or how much risk can you handle. What they’re looking for is the maximum amount of investment risk you want to accept – not what you actually need to accept. But there’s a big difference! Many investors don’t actually need to risk a lot, and shouldn’t! And every investor should be aware of this difference and know what your own level of risk should be.
So, how much investment risk do you need?
It’s actually fairly easy to figure out. Much of it depends on your age and your ability to save. You can usually estimate how much investment risk you actually need by
- answering a few basic questions, like
- How much have you saved today?
- How much can you save each year?
- How much do you want to have saved as your goal?
- making a bunch of mathematical projections estimating the rate of return your savings need to earn for you each and every year, and
- having an understanding of the rate of returns for the different types of investments (i.e. bonds, GICs, stocks, real estate, etc.)
From my experience there are two simple factors that will influence your need to take investment risks:
- Your time horizon: In general, the longer you have to save for a goal, the lower your need to take on investment risks. The value of time is tremendous. Don’t take it for granted or underestimate it.
- Your ability to save: In general, the more money you’re able to consistently save, the lower your need to take on investment risk. If you can regularly save a lot of money, then you won’t need to take investment risks.
Here are 3 common investing scenarios that illustrate these ideas.
Example 1: Let’s say my 22-year old son wants to retire in 43 years with $1,000,000 saved. He has already saved $11,000 towards his goal and he plans to save $5,500 each and every year. How much investment risk does he need to take on to reach his goal? If you’re an investment advisor or you have been weaned on the investment industry’s marketing literature, then your answer will most certainly be that my son has the ability to take on lots of risk and should invest 100% in the stock market – after all he has 43 years to recover from any investment losses that result from bad markets, right?
But, I'm not asking how much investment risk my son wants (or “can accept”), but rather how much investment risk does he need to take on to reach his goal.
To reach his $1,000,000 goal, my son will need his savings to earn 5.47% on average over his 43-year investing time horizon. So, this fairly modest rate of return indicates that my son doesn’t need to take on much investment risk at all, and based on historical data, he can probably reach his goal by investing in low risk investments such as bonds and GICs. So the answer to the big question, then, is that to reach his goal, he doesn’t need to take investment risks with his savings at all, so he doesn’t need to invest 100% in the stock market.
Example 2: If, on the other hand, my son were 40 years old, that’s a whole different question! In order to reach his $1,000,000 goal, he would need to take on a lot of investment risk if he had those same savings from Example 1 to generate the 12.50% rate of return needed to reach his goal. In this case, he would need to invest 100% in the stock market and he would need to save more than his $5,500 per year.
Example 3: Sometimes an investor of a certain age suddenly comes into a substantial amount of income, and this increased ability to save greatly influences their need to take investment risks. I have worked for a number of clients in their 40s who had the ability to save $10,000 to $20,000 each and every month. Their ability to save large amounts helped to substantially reduce their need to take investment risks with their savings. That is, if you can save $10,000 per month and invest it in low risk investments earning 4.00% (such as bonds, GICs, etc.), then in 20 years you would safely have accumulated over $3,800,000. Again, here’s another clear example of an investor who doesn't need to take risks in investing.
So the next time you’re asked how much investment risk you’re willing to accept or how much risk you want, ignore that question and instead ask your advisor – How much investment risk do I need to take on? It’s a much wiser question for your wallet and your peace of mind.