When it comes to investing, more risk equals more reward (to an extent).
That’s simple enough to understand: If you keep your money in cash in your checking account earning close to 0% interest, you won’t lose it but it won’t grow either. No risk, no reward.
If you buy diversified bond funds (that own hundreds to thousands of bonds), you’ll earn a little more – a little more risk, a little more reward.
The same is true for investing in stocks. Well-diversified stock funds provide more risk but also more return. (Over the last almost 100 years, the US Stock Market has returned on average about 8% per year.)
So, why do I say to an extent? Well, tomorrow you could decide to put all your money in one stock. Maybe it will explode with 100% growth over the next year (unlikely) or maybe the company will go bankrupt tomorrow (also unlikely). In this case you’ve taken on more risk, but it’s too much risk for only the possibility of reward. (More risk in this case may NOT mean more reward.)
The problem is we don’t know what will happen. Some companies WILL experience big gains (at least for a finite period of time), while others WILL go bankrupt. Because we don’t and can’t know what will happen in the future, we should take on reasonable risk within our portfolios. And, the biggest driver of this is the mix of stocks and bonds in our portfolios.
You could have a portfolio that is invested in 100% stocks or 100% bonds…most people find themselves somewhere in the middle. It’s important to take on the right level of risk for YOUR goals, age, comfort, etc. (If market noise makes you panic, just stop checking every day! If you can’t do that, a 60/40 portfolio might make more sense than the 80/20 portfolio recommended for your age group – or whatever the case may be.)
Typically, the younger you are the more risk you can afford to take. Your time horizon is long, especially compared to a tiny little grandma who is in good financial shape, only has about 10 years to live, doesn’t spend a lot of money, and can’t stomach the market movements from day-to-day, or even year-to-year.
Here are some examples, based on Vanguard’s target retirement date funds:
Target 2020: 60% stocks, 40% bonds
Target 2030: 73% stocks, 27% bonds
Target 2040: 88% stocks, 12% bonds
Target 2060: 90% stocks, 10% bonds
Why only the small difference between the 2040 and 2060 target retirement funds? Well, data shows the reward added (in terms of additional growth) by moving from 90% to 100% stocks is only marginal compared to the added risk.
Think about the right ASSET ALLOCATION for you (this mix of stocks and bonds within your portfolio) and invest accordingly. You’ll change it down the road, as you get older, but for several years you shouldn’t have to. Especially when you’re young, the best thing you can do is invest a lot of money aggressively and let compound interest get to work.
Got it? If you have any questions for me, just ask!