7 Dumb Risks Retirement Investors Take
Reprinted courtesy of MarketWatch.com.
To read the original article click here.
Whether we like it or not, investing is about taking risks. That’s what we get paid for. However, as I wrote last month, if you aren’t careful you can become your own worst enemy by misunderstanding and mishandling risks.
Some risks are worth taking. For example, although stocks are riskier than bonds, there’s a well-established basis for expecting higher long-term returns from stocks.
Today I want to focus on seven important risks that don’t have an expected payoff. Since many people still think that investing means buying stocks, let’s start there.
1. Stock risk
Sometimes described as “business risk,” this is the possibility that a company whose stock you own goes down the toilet. Choose the wrong stock, and you’re in trouble. But we also know that choosing the “right” stock can result in great profits. If you want to make the most money, invest in one stock. If you want to lose your shirt, invest in one stock. Either way when you buy one stock, you’re not investing. You’re speculating.
Statistically, the expected return of owning a single stock is the same as owning “the market.” But the risk of owning one stock is the loss of all your money.
The cure: Own stocks by the hundreds, in some cases even thousands, through mutual funds and exchange-traded funds, or ETFs. There’s a word to describe this safety net: “Diversification.” That word should be familiar to every serious investor.
2. Industry risk
This is another version of stock risk. It’s the risk of putting all or most of your money into stocks in only one industry. I know very smart and accomplished people who made this error. Their thinking: “Hey (fill in the blank ) is a business I know. I know who the players are, who’s strong and who’s weak. I don’t know anything about ( fill in more blanks to describe other industries ). I want to put my money into things I understand.”
This has come back to haunt many people, from those who bet on atomic energy and airlines back in the 1960s to those who bet on Internet companies in the 1990s to those who bet on banking and real estate eight to 10 years ago.
The Nasdaq Composite Index, which is dominated by technology companies, peaked early in 2000 in a wave of optimism. In the next 2.5 years, the index declined by 78%. Today, almost 14 years later, it’s still worth less than 80% of its long-ago peak value.
Once again, the cure is the same: Diversify. Even if all you have to invest is $1,000, through mutual funds and ETFs, you can easily own stocks in dozens of important industries. You’ll be sure to have a stake in the Apples and Googles of the world. And the occasional Enron won’t sink your ship.
3. Country risk
This is still another version of the same problem: Having most or all your investments in stocks of one country. Plenty of people think U.S. stocks are all they need, especially since U.S. stocks include giant multinational powerhouses like Microsoft and McDonald’s.
But try to tell this to Japanese investors who, back in the 1980s, followed the “inevitable” logic of the day and put all their money in stocks of their own country. They are still waiting in many cases to “break even.” (The Japanese stock market index is still worth less than half what it was in 1989.) Try telling that to the 90% of investors in Greece who a few years back had all their money invested in Greek companies.
The cure? One more time, it’s diversification. For many years I have recommended putting half of your equity investments into international stocks, including those of emerging markets countries.
4. Asset class risk
Through ETFs and mutual funds you can easily avoid the previous three risks by owning thousands of stocks in dozens of industries in many countries. But it’s still possible that most of those stocks will behave in a similar fashion because they are in the same asset class. For example, large-cap growth stocks are popular throughout the world, but they don’t have the best long-term track record of superior risk-adjusted performance.
The S&P 500 Index SPX -0.06% , having gained more than 28% a year in the late 1990s, experienced a “lost decade” from 2000 through 2009, in which it lost about 1% annually. Meanwhile, other asset classes that I recommenddid much better. For example, small-cap value stocks were up nearly 12% a year, and international large-cap value socks were up more than 8% a year.
The cure, once again, is diversification into multiple asset classes that have been productive over the long run in the past.
5. Commissions risk
This is the risk that, by paying sales commissions, you will pay more than you need to for investments you buy, thus diminishing your potential profits.
It may be convenient and comfortable to have a salesperson choose funds for you and fill out the paperwork — but the cost is very high. Simple math says that if you invest $10,000 in a load fund and pay a 5% sales commission, you instantly lose $500; only $9,500 is invested. That’s a guaranteed, permanent loss.
Do you get a premium in return for taking that loss? A Harvard Business School professor studied thousands of mutual fund investments over six years from 1996 through 2002. The study found that investors in broker-sold funds on average made only 2.9% a year, less than half the 6.6% for investors in no-load funds.
6. Expense risk
This is the risk you will pay unnecessarily high continuing expenses for management of your money. This is most easily recognizable in the expense ratios of mutual funds.
Index funds often have annual expenses that are 1% below those of actively managed funds that own similar portfolios.
This may seem like a small item, but over a typical investing lifetime of 30 years or more, giving up 1% a year in return can easily cost millions of dollars.
Every study I’ve ever seen about expenses indicates that in any given asset class, the result of higher expenses is lower returns. Expenses are like slow leaks that seem insignificant at first — and then sink ships.
7. Tax risk
This is the risk that you’ll pay unnecessary taxes on your investments. One of the easiest ways to protect yourself from this risk is by putting as much of your investments as possible into tax-deferred accounts (tax-free in some variations) such as IRAs, 401(k)s and similar employer plans.
When you can’t do that and your money needs to be in a taxable account, you can reduce your tax burden with tax-managed funds and (if you’re in a high tax bracket), tax-exempt bonds.
The specifics of all these are too complex to detail here. The point is to think about taxes before you invest. Once you determine how you will allocate your assets, take one more step and find out if there’s a way you can carry our your plan with less tax impact.
There’s much more that can be said about these risks. To hear more, I recommend you snag my recent podcast on this topic.
Here’s what I recommend: Make it a rule never to take an investment risk that doesn’t give you an expected premium return.
Richard Buck contributed to this article.