My individual retirement account money is 100 percent invested in stock index funds. Let me tell you why.
It’s not because I think the stock market is about to take off. It’s not because I read some guru’s economic tip of the year. And it’s not because I don’t understand the risk of owning equities (equities is simply another word for stocks).
It is precisely because I do understand the risk, I have realistic expectations, and my choice is perfectly suited for my goals. Let me explain the three reasons behind my choice:
1. Risk. I consider risk the most misused word in finance. Everyone thinks they know what it means, but no one really does. How about a definition of risk everyone can understand? Ask two simple questions:
- Can I lose any money? If the answer is no, it’s a safe investment.
- Can I lose all of my money? If the answer is yes, find out what circumstances it would take to make that happen.
When you own a diversified portfolio of stock index funds, in order to lose all your money, thousands of the largest companies in the world would have to fail at once. Could this happen? Yes, but if it does, I don’t think I’ll much care about how much money is in my IRA. It's more likely I’ll be figuring out how to protect my property and grow my own food.
Could my investments be worth half their value in a few months? Absolutely. But what do I care? I don’t need the money in a few months. I need it in 20 years.
The fluctuations my account value will go through over the next 20 years is volatility. The risk in volatility for the average person is they get emotional, or don’t understand the investments they own and exit after a big bear market. I know I’m not going to do that, so volatility is irrelevant to me.
The real risk is that stocks simply don’t do well over the next 20 years, and I get to retirement and realize I would have had a better outcome by sticking with safe investments. That’s a risk I’m willing to accept.
2. Realistic expectations. I don’t expect my IRA to be up 30 percent this year. I don’t even expect it to go up 10 percent this year. I don’t really care what it does this year. I do expect that if I leave it alone over 20 years it will deliver a decent return.
If I get a bad 20 years, I think I’ll still earn more than zero. If I get a good 20 years, I’d expect it would average 12 percent or more a year. An average annual return of somewhere between zero and 12 percent is what I expect.
Why so broad a range? Because I have no control over what market conditions the next 20 years will deliver. All I have control over is how I invest. And I know if I kept all of my money in safe choices, it wouldn't have a chance of earning 12 percent a year, although it would earn more than zero.
I also expect that around every eight to 12 months, my accounts will drop about 10 to 15 percent in value. Why do I expect that? That’s about how often market corrections occur. In addition, I expect that a few times over the next 20 years, I might watch my account values drop by 30 to 50 percent. Like market corrections, bear markets are not rare.
Because my expectations are in line with reality, I am completely comfortable investing in equities. In addition, it is the choice that most aligns with the goals of my retirement money at this point in my life.
3. My goals. How do I know my retirement money has 20 years? Well, I think I’ll likely be working until age 70. Not because I have to, but because I get bored easily and enjoy work. I’m currently in my 40s.
Retirement money is a protected asset when it comes to creditors. That means that even if I royally screw up and end up filing bankruptcy (I certainly don’t anticipate that but life can throw some nasty curve balls), I still wouldn’t cash in my retirement money to try to save the situation.
I also know I won’t panic and bail out of the market when it goes down, because I know it will go down from time to time.
Put all this knowledge together, and I know my retirement money has at least 20 years. My goal over that time frame is to earn the highest return possible. Deciding to invest it all in stock index funds is the option most likely to meet my goal. I realize higher returns are not a certainty. I also know that as I move closer to retirement, I will make changes to my portfolio and gradually add in safer choices.
I have other non-retirement money. And you know what? It is 100 percent invested in safe investments. It earns almost nothing. Why do I leave it there? Because my livelihood is tied to the financial markets, and when the bear markets I expect come along, it is likely my income will go down. During those times, I will need cash reserves, and I don’t want those tied to the stock market.
Even if it is your retirement money, and you have twenty or more years, a 100 percent equity portfolio is not for most people. Too many people mistake volatility for a permanent loss, and are prone to buying high and selling low.
Regardless of the final
allocation of your investments, you can become a better investor by asking
questions about risk, setting realistic expectations and having clear goals.