If you are a regular church attendee think about how often you learn a completely new concept on a Sunday morning. I mean a concept that you’ve never heard before.
Have you thought about it?
I’m guessing it is very rare that you learn a completely new concept.
In fact, you probably learned most of the new church concepts when you were a child in Sunday School up to maybe your early 20’s in a young adult class. After that most of the teachings are generally a repeat of what you’ve already been taught.
And that’s actually a good thing.
Because every time you hear those same concepts taught with a slightly different perspective, a slightly different angle, you begin to see how they can be applied in new ways. You begin to see that the meaning has sunk deeper into your fibers.
It’s easy to quickly know something in your head. It takes time to know it in your heart.
Most of the time we are more in need of reminders than new information.
It turns out the same thing applies to an investing truth. I’m referring to the risk / return trade-off.
The head knowledge of this truth is pretty simple:
“If I’m going to take more risk with my investments then I want to be compensated with more return potential over the long-run. “
This concept is easy to understand. If you were going to lend your money to an FDIC insured bank, you may not demand a very high return on your CD since there is virtually no risk in that account.
However, if you’re going to lend your money to a new start-up business that could potentially fail, you are going to demand a much higher expected rate of return. You may even want some collateral too.
But the application of this truth can be difficult.
If it is true that the more risk you take the more return you expect, then the flip side of this should also be true:
“The more return I get over the long-run, the more risk I must have been taking with my investments.”
Why is this true?
First because of the risk / return trade-off described above.
But also because the markets are rather efficient.
[“Efficient” simply means that if there is an opportunity to make higher returns in relation to the amount of risk being taken, investors will generally jump in to buy that investment. This will eventually bid up the price of that investment until the expected returns are back in line with the level of risk that is being taken.]
Therefore, if you are getting really strong growth on your portfolio over the long-term, it may be because you are investing very aggressively and exposing yourself to a lot of risk.
Whether you are comfortable with higher risk or not comfortable is a matter of personal preference. But isn’t it good to at least know that is what you’re likely doing?
The Great Investment Temptation
Let’s say you have a diversified portfolio.
By definition it will have some winners and losers in it if it’s properly diversified. Not all asset classes go up and down together. When some are “winning” others may be “losing” at any given time.
The great temptation then is to look at what the S&P 500 index by itself did over the last 1-, 3-, 12-month period. Especially if it had phenomenal growth.
You may ask, “Why didn’t my portfolio grow like that?”
The answer to that question could very likely be, “Because your portfolio was diversified to help reduce risk.”
The photo negative of this temptation is when your diversified portfolio goes down. Then you may look and see what a stable bond index fund did during that same time. It probably didn’t go down as much if at all.
You may ask, “Why did my portfolio go down more than the stable bond index fund?”
The answer could very likely be, “Because your portfolio was diversified to help increase expected returns.”
If a stable bond index fund has low return potential, then it should be no surprise that it has lower risk and less downside potential when the markets (or even your portfolio) have a correction.
Simple Truths Should Be Revisited Often
It’s simple to understand but the hard part is putting it into practice.
Especially when there is a lot on the line, like when you’ve retired, no longer have a paycheck, and you recognize just how dependent you are on your portfolio to help supplement your Social Security benefit over what could be a two decade-long retirement.
This is why it’s so important to have a plan in place to help you figure out how you’re going to replace your paycheck in retirement.
This is because for most people their investment portfolio will play a crucial role since Social Security will not come close to replacing your paycheck in retirement.
A plan helps you think long-term. It helps you see what investment return potential you need to pay for your living expenses over a two decade-long retirement. It will help you see what level of risk you may need to take to get the potential return necessary to afford your lifestyle in retirement.
In short, it helps you to better apply the principal of risk / return trade-off.
The most important truths in life are usually easy enough for a kindergartener to grasp in their mind. But they typically take a lifetime to internalize and apply.
That’s why we need reminding along the way. And we need support mechanisms in place to help apply the truths. For religion that support mechanism may be weekly meetings.
For retirement planning it may be a solid plan that you know will work and that you can stick to long-term.
If you need help with the planning part, click below and fill out the form. I’ll reach out to you and see if I may possibly be able to help you.