Personal Finance

The Biggest Risk in Financial Planning: Avoiding Risk

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Editor’s Note: This story originally appeared on NewRetirement.

Up until at least three years ago, across all generations, Americans tended to steer away from risk. It will be interesting to evaluate if that attitude is further entrenched or has shifted after the COVID-19 pandemic.

Avoiding risk has been the prevalent attitude in all areas of Americans’ lives. And, a study found that risk tolerance fell between 2009 and 2019 — perhaps due to fallout from the 2008 financial crisis. In 2019:

  • 38% of Americans were less comfortable than 10 years earlier taking a risk with their finances.
  • 65% were less comfortable taking risks in their careers.
  • 76% preferred to live in one place, even if that means passing up opportunities to make a positive career move or increase their income.

And, when it came to investing, the majority of Americans — a full 79% — preferred lower risk and more stable savings and investments.

But avoiding risk might be a huge mistake. Here’s why.

Avoiding Risk — Isn’t That a Good Thing?

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Is avoiding risk a good thing or bad?

The answer is that it depends, but avoiding all risk is definitely not good — especially in your investments.

According to experts, one of the biggest risks in financial planning isn’t investing in a volatile portfolio, but rather avoiding risk altogether.

“Let’s talk about a huge risk: the risk of avoiding risk,” says certified financial planner Leon LaBrecque, of Troy, Michigan-based LJPR, LLC. “All too often I see clients who sit in cash, paralyzed by the next ‘big downturn.’”

While investment strategies vary for each person, financial planners say taking some risks is important in maintaining a healthy — and growing — retirement portfolio, even in the worst economic times.

Here are some things you should consider when deciding whether to take risks in your investment portfolio.

1. Are We in a Bubble?

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In November 2021, the stock market hit an all-time high. This is objectively crazy considering we are still emerging from a global pandemic. And, some experts say that the bubble is about to burst.

If you are invested now, you may be somewhat worried. The trick is to know your investment goals and have a plan for what you will do if the burst happens. Learn about the benefits of having an investment policy statement.

And, if the markets crash, here are 10 surprising moves to make.

2. Remember: No Risk, No Return

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No risk, no return: That’s the mantra of the financial planner, says Rick Kagawa, certified financial planner and president of Huntington Beach, California-based Capital Resources and Insurance Inc.

“Having no risk in your investments equals no returns,” he says. “If you have no returns, then you must generate all the money for whatever your goal is. This makes reaching your goal much more difficult to nearly impossible.”

The most common no-risk account is a bank account, he adds, noting that there has never been a time when you could make money in this savings vehicle. “The fact is, your money shrinks with inflation and taxes in a bank account,” he says.

You may be thinking a bank account is still safer than investing in stocks, which could plummet again and devastate your investments. But you’re wrong — for the most part.

3. Yes, Markets Have Gone Down, but They Have Always Gone Back Up

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The stock market goes up and down in the short term. Over the long haul, it has historically done nothing but go up and to the right.

Even a worst-case one- or two-year contraction of the economy will likely eventually rebound.

So, most of the time, it is important to remain calm, don’t let emotions or stress take over and just do nothing. Ignore it.

And even if something cataclysmic were to happen to the markets for them to permanently fail, money will probably have no meaning in such a doomsday event. We’ll have much, much bigger problems to worry about.

4. You Need Some Risk to Keep Pace With Inflation

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When you are working, your salary is supposed to keep pace with inflation. So, if costs go up, your pay is supposed to go up too.

However, when you are retired, you are usually living to some extent off of your savings. If you are invested without risk, then you may have a hard time with the spending power of your money. You need your investment returns to be at least equal to if not greater than inflation.

You will essentially lose money if you don’t adopt some risk.

5. Don’t Be Ruled by Fear

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The worst thing you could do is let fear determine where and what you invest.

“I think a huge risk is fear, and history tells us that fear itself is what we really need to fear,” says LaBrecque.

6. Taking Calculated and Balanced Risks Is Key

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Of course, you shouldn’t dump all your money into stocks and see how it plays out. Instead, invest in a well-diversified portfolio and take calculated risks.

Roughly one-fifth (21%) of survey respondents in the Northwestern Mutual Planning and Progress Study said they prefer taking calculated risks in the pursuit of higher returns.

But these risks should also be balanced with certain “less risky” investment vehicles. Deciding which vehicles to invest in depends on when you will need your money, says Scot Hanson, certified financial planner at Shoreview, Minnesota-based EFS Advisors.

“For long-term money, go with higher risk, higher reward mutual funds and try to put those in your Roth IRA,” he says. “For money that you will need fairly soon, do not [take] a risk. Keep this in cash, CDs [certificates of deposit], or a low-duration government bond. You will not make much, but you will not lose much either. And make sure you do not put too much in this pot of money.”

The key is to take some risks, but also put some money aside in “safer” investment vehicles.

7. Consider a Bucket Strategy

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A bucket strategy is when you allocate your money into different buckets. Some of your money is invested with more risk while other amounts are placed in safer types of investment vehicles.

Learn more about bucket strategies.

8. When Not Taking Risks Makes Financial Sense

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As a general rule, start reducing market risk at around age 55, depending on when you will retire. Do this by using managed accounts in which the goal is to avoid high draw-down, says Michael Black, certified financial planner and owner of Scottsdale, Arizona-based Michael Phillips Black Wealth Management.

“Once you go into distribution mode, avoiding large market moves is critically important,” he says. “When you’re retired, the avoidance of draw-down is more important than achieving appropriate returns.”

It’s not surprising then that baby boomers (ages 51 to 69) are considerably more risk-averse than Generation X (ages 34 to 54) and millennials (ages 18 to 34).

In fact, 83% of baby boomers are more comfortable reducing risk to ensure the safety and stability of their savings, even if it means a lower potential for returns, the Northwestern Mutual study finds.

In comparison, 74% of Gen Xers and 71% of millennials feel the same.

9. Work With a Financial Adviser

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The Northwestern Mutual study found that American adults who worked with an adviser reported an average risk tolerance of 5.2 on a scale of 1 to 10, while those without advisers had an average risk tolerance of just 4.6.

Trust the experts. They can help you adopt a sane attitude toward risk.

10. Understand Diversification

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Different investment classes have different purposes. Stocks can be good for growth if you have a long time horizon. At the other end of the spectrum, a lifetime annuity is designed not for returns, but to guarantee income.

You want to diversify your money into different assets that meet your personal needs.

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