Mental Money Mistake 3

This is the third article in a series titled “Mental Money Mistakes.” What are mental money mistakes? They’re subtle errors in judgement; basic oversights and miscalculations. As a rule, they tend to be subtle and easy to miss. I don’t mean big mistakes like taking on a bunch of debt, spending more than you can afford, or being too risky with your investments. No, these are the kinds of mistakes just about anyone can make, even if you’re intelligent and hard-working.

Mental Money Mistake #3: Being Too Afraid of Risk

Most investors know how important it is to avoid taking on more risk than they can afford. That’s why advisors like me spend a lot of time going over concepts like “risk tolerance” with our clients. After all, no one wants to get burned by a bad investment and end up losing a hefty chunk of their nest egg.

But did you know that it’s possible to be overly risk-averse? Some investors are so afraid of losses that they end up missing out on opportunity after opportunity, and in the end, simply don’t have the funds they need to accomplish their financial goals. When that happens, they’re really no better off than the investor who risked too much, are they?

Take this example.

Imagine two relatively young investors, both in their mid-thirties. Let’s call one Jim and the other Alice. Both Jim and Alice know they need to save for retirement, and decide to invest$5,000 per year for the next 30 years. Unfortunately, Jim is extremely cautious (to the point of timidity). He’s so anxious to avoid risk that he decides to put most of his money into Certificates of Deposit, or CDs. CDs are traditionally seen as fairly safe, so Jim feels good.

Alice, meanwhile, is also cautious but decides to invest more heavily in stocks. Over the next thirty years, she sweats the ups and downs of the markets like most of us do.

Now fast forward thirty years. Both Jim and Alice are in their mid-sixties and getting ready to
retire. For simplicity’s sake, let’s say that Jim earned about 2% interest a year on his retirement savings.  When you factor in compound returns, Jim ends up with about $211,000.

Alice, on the other hand, ended up earning about a 7% annual return. Some years were higher, some were lower, but the average is 7%. (This is a fairly conservative average, but it makes things easy to calculate.) She ends up with almost $510,000. That’s over twice as much as Jim. That means she has a lot more money saved up for retirement … and lot more to apply to her financial goals.

All because she was willing to take on a little more risk.

This same principle applies to retirees, too. Of course, retirees should invest more conservatively than younger investors.  But again, that doesn’t mean they should sacrifice all potential for growth. You see, many retirees often discover that the money they saved can dry up pretty quickly, especially on things like medical care. Retirees need income, and allocating at least a portion of your portfolio for growth is a good way to generate that income. That means accepting at least some risk, even when you’re retired.

The fact of the matter is that all investing involves some risk. While it’s crucial that you avoid taking on too much, it’s also important to not take on too little. So as you save and invest for the future, take time to determine not only how much risk you can afford … but also how little.

Keep an eye out for next month’s letter, where we’ll discuss Mental Money Mistake #4:Following the Crowd.