The second question you must answer according to Larry Swedroe’s investment risk framework, is, “How much risk is wise for me to take?” It could be that you need to take risk to reach your financial goals, but taking risk would not be wise. This would put you in the unfortunate position of not being able to reach your financial goals without taking foolish risks that are not worth taking.
How do you determine how much risk is wise for you to take? Swedroe identifies two major factors; (1) your investment horizon, and (2) the stability of your earned income.
Your investment horizon refers to how long you have until you need to withdraw a substantial portion of your investment. Stocks have proven to be a great investment over fairly long periods of time but the volatility of the stock market makes equities a poor choice if your time horizon is short.
Jeremy Siegel, in his excellent book Stocks for the Long Run, reports that, since 1802 stocks “have never delivered to investors a negative real return over periods of 17 years or more. Siegel also reports that “for 10-year horizons, stocks beat bonds and bills about 80 percent of the time.”
As the time horizon shortens from 10 years the risk of loss goes up. If your time horizon is less than 5 years you should minimize your exposure to the stock market. For example, a high school sophomore who is saving for college would be unwise to have a high exposure to the stock market.
It is also important to accurately calculate your time horizon. If you have saved enough to last for a retirement of 30 years than you may still have a long time horizon in the early years of your retirement. If you are fortunate enough to have more than enough saved for your retirement than you are, in essence, investing for your heirs or for charity. In that case your time horizon might be infinite.
Stability of Earned Income
Moshe A. Milevsky, in his book Are You a Stock or a Bond: Create Your Own Pension Plan for a Secure Financial Future, writes about how the stability of your income affects how much investment risk you should take. The basic concept is that if your job (or your life) is more like a bond (stable and predictable) than you can afford to take more investment risk. On the other hand, if your job (or your life) is more like a stock (volatile and unpredictable) than you should minimize investment risk.
For example, if you are a tenured professor, work for a government entity, or have other very stable employment then you can prudently take more risk with your personal investments. This is particularly true if you are lucky enough to have a job with an actual defined benefit pension plan. In that case some of your retirement income is already bond like, which allows you to take more risk with your personal investments. Conversely, if you are an entrepreneur or salesman then your income is more stock like (volatile) and you would be wise to take less risk with your personal investments.
Taking unwise investment risk is a recipe for disaster, so along with your future financial needs and goals don’t forget to consider your investment horizon and the stability of your earned income when deciding how much investment risk to take.