The best way to invest your money successfully is by understanding your goals. That’s why the best financial advisors build financial plans before making investment recommendations. Once they know when the money will be needed and how much, they can recommend an appropriate asset allocation and specific investments.
Since you’re investing to accomplish a goal, the main risks to protect against involve things that will prevent you from accomplishing that goal. Three main ones, and how to address them, are:
Build a financial plan outlining future spending goals, like having a great retirement, paying for college and weddings and all that stuff that makes having kids awesome (costly). Establish savings targets to hit those goals. Assume reasonable rates of return. Check-in on the plan at least annually. Make sure your portfolio is managed well according to it and make necessary adjustments.
As costs increase, your money’s purchasing power decreases. If a dollar in the bank earns .5% interest and inflation is 2.5%, every year your money loses 2% of its purchasing power. It might not seem like much, but over years it adds up. Between 1999-2019 a dollar lost 35% of its purchasing power to inflation, and that was a period with below average inflation. Between 1970 and 1990 a dollar lost 70% of its purchasing power!
Inflation is a risk to protect against. The good news is it’s an easy fix. Money that you won’t need for a few years should not be sitting in cash exposed to inflation’s gradual erosion. Instead, it should be invested in things that grow faster than the inflation rate, the exact mix of investments again depending on your financial plan. This also helps you achieve your long-term goals since it’s likely you will need help from the stock market to turn your savings into enough money to fund future spending goals. Read How Does Inflation Impact Investors? for more.
This is the big one.
“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No.1”
– Warren Buffett
Capital risk is a permanent loss of some, or all, of your capital. Investments come with volatility, and volatility is one definition of risk. However, a volatile investment that fluctuates in value is not the same as an investment goes to zero. You cannot recover from zero.
Conquer capital risk by:
- Avoiding speculative investments: Do-it-yourself options trading, penny stocks, start-up companies and opportunities, and other lottery ticket type investments should be avoided.
- Investment Diversification: A stock that goes to zero in a portfolio of five stocks is a 20% loss of capital (we’re assuming the stocks are equally weighted here). In a twenty stock portfolio, it’s a 5% loss of capital. In a one hundred stock portfolio, it’s a 1% loss of capital.
- Asset class diversification: If you own just stocks and need money during a downturn, you will have to sell stocks at a loss and lock in the decline. This may not be a major issue if the withdrawal amount is minor and part of your long-term plan. However, other asset classes like bonds give you the opportunity to free up cash from your portfolio when you need money.
- Panic selling: Stocks are volatile investments. If you didn’t know that before this year, you do now. In the long run, that volatility evens itself out and the performance earned from your stocks should line up with the performance of the businesses you own. Short-term that is not the case, and there is massive temptation to sell stocks during scary times. Resisting this temptation protects against permanent loss of capital. I’ve used this chart before, but it’s one of my favorites and deserves another look. Don’t let what can happen in shorter periods knock you out of the long-term returns you can achieve by standing pat during bad markets.