Monday, March 23, 2009

The 7 new rules of financial security

Posted by YiLin Zhu

Rule No. 1: Risk

Old thinking: If you can stomach the ups and downs that come with risk, you'll be rewarded.

New rule: Risk isn't about your stomach. It's about making or missing an important goal.

You know you have to consider risk. But what is risk? Many of us have learned to think of risk as synonymous with volatility. For years, what came down reliably bounced back even higher. You could easily conclude that risk tolerance was just a matter of taste. As long as you had the fortitude to see the occasional loss on your 401(k) statement and not panic, you would capture superior returns over time.

As you now know, the "over time" part of that last sentence is the real risk of relying too heavily on stocks. The longest period of negative returns for U.S. equities is 16 years, according to data collected by Wharton economist Jeremy Siegel. And we're at over a decade as of late February.

If you hit a slump in returns at the moment you need the cash, the eventual upside of volatility won't do you much good. Consider the analysis above from T. Rowe Price, which shows the impact of a weak market in the first five years after you retire. Because you have to sell falling assets to live on in the early years, your portfolio may be so small by the time the rebound comes that you still run out of money.

What to do: You shouldn't run from risky investments just because they lost money - that train has left the station. But the old buy-on-the-dips advice isn't quite right either. This bear market's lesson is that how much risk you can take is a matter of how much you can lose and still meet your basic goals. That may mean scaling back on stocks, even if you miss some of the next market rebound.

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