In this series I am covering the 24 tell-tale signs that you could be in financial trouble. Over the next few weeks I will be presenting these signs, how to identify them and tips on how to address the issue.
Having the ability to save and invest money is a great start but that is only half the battle. You can save a lot of money yet do considerable damage to your finances by not investing it appropriately for your situation. Granted, saving something is better than nothing but the long-term effects poor investment choices can severely impact your finances.
Thinking About Risk
Everyone has their own risk tolerance and this tolerance generally changes as a person ages or different life events occur. Typically the younger you are the more risk you should be comfortable in taking and as you age you become more conservative. While this may generally be true nobody fits into a perfect mold based on age alone.
The main problem people have is not understanding risk and because of that they invest in a way that is either leaving money on the table or causing them to lose money when they can’t afford to. Most people simply categorize risk as the chance they will lose money but there are many other forms of risk to consider with all investment vehicles:
- Market Risk: The most commonly thought of type of risk. Stocks in the market go up and down so investments in these securities can fluctuate and possibly even drop to zero in extreme situations.
- Credit Risk: Fixed income securities like bonds also carry risk. Just because they pay a fixed interest doesn’t mean they safe. Just like people, companies carry the risk of being unable to repay the lender which could lead to the loss of your principal.
- Interest Rate Risk: Going along with credit risk and fixed securities is interest rate risk. Since many of these investing vehicles require money to be locked in for a certain period of time interest rate changes up or down can have an effect on your underlying holding and/or mean you are leaving money on the table when higher rates become available.
- Inflation Risk: This is the big one that most people don’t think about. Even if you have a 100% guaranteed investment either through an FDIC insured product or a government issued bond you are still subject to inflation risk. On average the annual rate of inflation is roughly 3%. This means even if you are earning a guaranteed 4% return on your money you are in reality only earning 1% before taxes. If inflation rises even slightly you are at the risk of actually losing money on a “guaranteed” investment.
Age is Only Part of the Equation
There are many different asset allocation models out there that tell you how you should invest based on your age. Unfortunately like much of the financial advice out there this is very general and should only be used as a guideline as everyone’s individual situation is as unique as the number of stocks in the market.
Some people have basic formulas that say 120 – your age equals the percentage of money you should have in stocks, others say 100 – your age, and there are even many other fancy calculations you can find on the internet to tell you what you should do. While this general rule of thumb is a good start it is far from the only thing you should be considering.
For example these calculations don’t take into account what type of stocks you are holding. You can adhere to the 90% stock and 10% bond rule yet find your allocation either extremely conservative or extremely aggressive. Not all stocks and bonds are created equal and these guidelines do not tell you how to further allocate those investments.
Your Specific Needs Matter Most
Even if you take the time to create the optimal portfolio based on the breakdown of stocks and bonds as well as ensuring it is diversified among those investments it still may be misaligned from your actual needs. Let’s first take a look at a 26 year old who just got married and they both have decent jobs and little debt. Common knowledge leads us to believe these individuals are in a position to be in at least 90% stocks so the couple invests in a few target date funds suitable for their situation. They are on the path to financial prosperity in retirement, right?
What if I told you that this couple had virtually no savings and planned on buying a house and starting a family in the next 1-2 years? They are maxing out their retirement plan contributions but have overlooked the requirement of creating a safety savings cushion or even working towards a down payment on a home. While it is great they are pumping as much as they can into a stock-heavy retirement account they are actually overlooking a few very important near-term needs. In this specific situation the 90/10 rule is not appropriate for them. Yes, they may want to keep their retirement plans allocated like that but they need to put a large portion of their money into cash-equivalent savings which could mean their actual overall allocation is maybe 50/50 which would seem very inappropriate for a very young couple with no debt.
I’ve seen just the opposite happen as well here with the retirement plan I work with. There are many employees in their 20′s who are invested 100% in their guaranteed rate fixed fund. It earns 4.15% right now. I don’t know their specific situation in order to determine if this is right or wrong for them but I would have to guess that this is not what they should be doing. Many probably signed up with this investment because they were scared or not informed of the benefits of the other investment choices. But if these people remain in this fixed account for any significant period of time they are probably going to be missing out on a lot of money that could have been made.
This Can Happen When You’re Older as Well
Just as a young couple can appear to be on track but overlooking an important immediate need the same is true for those who are approaching or in retirement. When I worked at a bank as an advisor I saw this all too often. I would encounter many individuals who were in their 60′s and had virtually 100% fixed income. In some cases it was nearly half a million dollars in a savings account or CDs earning 2-3%.
It this person was relying on the steady interest check generated from these investments as income to live off of, then yes this could be a suitable strategy. Unfortunately most of the people in this situation were not even using the interest that was generated and had no plans to for at least 5 years. Some were working on the side, others had pensions or relied on Social Security. So in this case these people are not even earning enough interest to keep up with inflation so they are actually losing money. Losing money is the whole reason they avoid stocks yet they fail to understand that even though the account is slightly increasing in value that their buying power is decreasing.
So in a situation like this people are doing what they were always told, and that is to move from stocks to “safe” investments when they retire to secure their money. Well, even if you are 70 and you aren’t relying on that money to live off of that doesn’t mean you should lock it up into something that protects your principal. Doing so could actually cause you to lose money thanks to the power of inflation while you leave a lot of potential money on the table that could have been gained by investing appropriately for your situation as opposed to just your age.
What Should You Do?
At the very least you should look at the various allocation models for a starting point. Generally speaking the younger you are the more you should have in stocks. Just remember that it doesn’t stop there. Take a look at what your actual holdings are to determine the real risk. Then take a look at other aspects of your situation that could affect your underlying investments. Maybe you plan on moving, you could be getting a new job, maybe a child is on the way or a home purchase is in your future or maybe you are shooting for an early retirement to start a business. All of these things are important to consider when creating your wealth so that you can invest appropriately in order to reach your goals, not just reaching a rule of thumb.
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About the Author: Jeremy Vohwinkle is a Chartered Retirement Planning Counselor® and spent a few years working as a financial planner. Today, he helps people make the most of their money by writing about personal finance here and elsewhere on the web. Jeremy is also Coach at Adaptu and a regular contributor for other publications such as Intuit, and American Express. Be sure to follow Jeremy on Twitter or Google+.