Avoiding risk? You might not be

Posted by on February 13, 2012 @ 1:18 am in Investing

I don’t consider myself a risk-taker. I change the batteries in my smoke detectors, double check that my doors are locked, and always wear my seat belt. I can absolutely relate to the fear that many young people have when it comes to investing.

My fellow blogger Karin Risi recently wrote about how Generation Y is inherently risk-averse when it comes to investing in the stock market. As a member of “Gen Y” myself, I understand risk aversion. We’ve seen our families lose significant wealth. We’ve seen loved ones lose their jobs and their homes, and we’ve struggled to find jobs ourselves. There’s no doubt that our experiences and the volatile returns we’ve witnessed over the past few years make it difficult to stomach putting our well-deserved earnings into the market.

And yet, there’s very real risk in not investing.

If you’re trying to avoid risk by staying out of the market, you might actually be taking more risk than you realize. If you’re sitting on the sidelines, you’re not only risking that your money won’t keep pace with inflation, you’re also potentially increasing the amount that you have to save to reach your goals.

For example, say that you have a goal of accumulating $1 million by the time you retire. If you assume an average annual return of 5%, you’d need to save about $900 per month for the next 35 years to reach your goal. Seem like a lot? Consider the alternative. If you assume an average return of 1% from savings accounts, you’d need to save about $2,000 per month for the next 35 years to reach the same goal. This simple calculation doesn’t consider the added impact of inflation. Since the money you save now may not be worth as much when you retire, you may need to save even more.

These numbers aren’t meant to scare you (the last thing you need when you’re fearful of the market is a scare tactic). The example above just provides you with some perspective so you can weigh your options and make the best decisions.

In recent posts, I’ve described the benefit of starting to invest at an early age. After writing Need Proof? I talked to a few Gen Y friends about their thinking when it comes to investing. Not surprisingly, as a whole, they’re hesitant about investing—afraid they’ll lose money, unsure of how to start, and preferring to spend money in other ways, among other reasons.

Here are some strategies that I’ve discussed with friends that may help make getting started with investing a little easier for you:

1. Match your investing to your goal. If you’re saving for something that you want to buy within the next year or two, it makes sense to avoid the volatility of stocks; however, if you’re saving for something 30–40 years down the road, like retirement, you have a much longer time frame to weather market declines—and stocks are likely to make sense.
2. Invest a small amount, often. Maybe you’re struggling with the idea of moving a large sum of money into the market, out of fear of losing your principal. Instead, consider automatically investing a small portion of your paycheck on a regular basis.
3. Consider indexing. One possible way to help reduce the risk inherent in any single security investment is to diversify your single investment into many investments. One example of this approach is an index fund. Because index funds invest in a representation of securities in a market index, one index fund can be a diversified investment. Index funds can also have lower costs than other funds, potentially allowing you to retain more of your returns, all else being equal.
4. Consider a fund that invests in other mutual funds (an “all-in-one” fund or “fund of funds”). These can simplify investing by offering the convenience of a single investment, while providing a diversified portfolio. Be aware that they’re subject to the risks of their underlying funds. Vanguard’s Target Retirement Funds, for example, gradually shift their emphasis from more aggressive investments to more conservative ones, based on the target date in the name of the fund (which refers to the approximate year when an investor in the fund would think about retiring).

It’s true, there’s no realistic way to eliminate all risks. For example, an investment in a Target Retirement Fund is not guaranteed at any time, including on or after its target date. But doing your research and making an informed decision about what’s right for you is a good place to start.

For the seasoned investors out there, what ideas do you have to help Gen Y start to invest?

Note: Diversification does not ensure a profit or protect against a loss in a declining market. All investing is subject to risk.

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