Making choices in your 401k account can be confusing without a little education. I work with young professionals to optimize their 401k contributions and investments so they can avoid common pitfalls. Here I want to take a look at a very common problem; not understanding “investment risk”. The key lessons from this article are how a lack of understanding about investment risk can cause you to take too little risk, and why understanding your capacity for risk is different and helpful to understanding your “risk tolerance”.
401k Investment Allocation Given Age and Goals
Many young professionals I’ve spoken with don’t understand the options available in their 401k. As a result, they follow the path of least resistance when setting up their 401k account.
At the beginning of your 401k account set up, you will likely be given a questionnaire related to “risk tolerance”. These questionnaires do a marginal job, at best, in estimating how much risk is appropriate for you.
One reason for this is that you may have no idea what “risk” means in terms of an investment. And if you have no idea what “risk” means or how it’s measured, then you will have a hard time imagining the implications outside of the absolute worst case scenario; i.e. losing all of your investment.
Because of this, you may end up being more conservative than you would have had you all the information. If you have been too conservative in that questionnaire at the beginning of your 401k account, you may choose a less than adequate investment selection.
What is “Risk”?
In the investment world, risk is most commonly measured as “standard deviation”. Standard deviation is a statistical term that describes how much something varies from it’s average.
For example, a mutual fund may have an average return of 7% per year and a standard deviation of 8%. That means in any given year, it’s normal to see returns ranging from -1% to 15% (7-8, to, 7+8).
This is what that questionnaire you fill out before setting up a 401k account (and many other accounts) means by risk. They want to see how comfortable you are with the ups and downs of the market. If you are less comfortable with ups and downs, then they will suggest investments that have less standard deviation; if you’re more comfortable with ups and downs, they will suggest more “volatile” investments.
The other thing you need to know about investment risk, aka standard deviation, is markets demand higher returns for more risk. This means if you offer me an investment with a really low standard deviation, i.e. low risk, I won’t demand a higher return because I am more certain of the return.
In the example above, the stock has a standard deviation of 8%. Statistically, that means there is a 68% chance your return could be anywhere from -1% to 15% in any given year. Because of the enormous uncertainty involved, investors will only make that investment if the investment can make a higher return; i.e. 7%.
On the flip side, if you had an investment with a 1% standard deviation, there’s a 68% chance your return will be +/- 1% of the average. In fact, you can take it further and say that (theoretically) there’s a 95% chance that your investment will return +/- 2% (i.e. 2 standard deviations) away from the average return in any given year. This means you wouldn’t require as high a return because it’s not as risky (i.e. it has a low standard deviation).
How Much Risk “SHOULD” You Take?
Now that you know what risk means for your investments, you should ask how much risk is appropriate? The way I answer this question is by looking at my situation from 3 angles:
- How long is this money ideally going to be invested? The longer, the more risk is appropriate. I’m 32, I have a while, so I can take plenty of risk.
- How might an unexpected financial emergency impact this money? The less likely you are to break into your 401k to make ends meet, the more risk is appropriate. I live in a two income household with an emergency fund, so with that in mind, I’ll take more risk.
- Are there any special considerations to take into account? If you have a goal of early retirement, you may need to generate a higher return to meet your goal. Personally, I’d love to check out by 45 and travel the globe in an RV or something like that; I’ll need a pretty decent return given my rate of savings to achieve that.
Notice that I haven’t asked myself any questions about how I “feel” about “risk”. I’ve omitted any questions of feelings about risk because I’m not trying to judge my risk tolerance, but my “risk capacity”.
The difference is that capacity for risk is the prudent amount of investment risk an informed person would take based on your financial situation. Risk tolerance refers to how “comfortable” you are with any given level of risk. But your knowledge of investment risk and risk capacity is going to impact how comfortable you feel about risk.
Imagine the difference this makes for a 25 year old with very stable earnings, an adequate emergency fund, and decades of work ahead. Absent any knowledge or context about investment risk or their capacity to take investment risk, they may default to any hypothetical portfolio suggested to them.
But since there is an trade off between risk i.e. standard deviation and return, not knowing what it means for an investment to be risky could mean the difference between thousands of dollars.
Imagine two employees saving 6% of their $70,000 salary (salary growing at 3%/yr.). If one earns 6% and the other earns 8%, they will have a ~$51,000.00 disparity between them after 20 years! That means despite investing the same amount over the same period, they have very different outcomes based on a 2% difference in rates of return.
The main takeaway here is that understanding investment risk aka standard deviation, is not difficult for most people to grasp. Understanding capacity for risk, i.e. your ability to take risk given your age, goals, and special circumstances helps you frame how much risk is appropriate. Taking too little risk is a risk itself and can mean the difference between retirement and a longer working life. Finally, if you think you may not have an adequate asset allocation, you can change your investment allocation in your 401k.
Erik Goodge is a CERTIFIED FINANCIAL PLANNER™ and the President of uVest Advisory Group. He holds a B.S. in Economics and Cognitive Science from the University of Evansville. Erik is a Marine Corps veteran of the Afghanistan campaign and Purple Heart recipient. He is from Evansville, Indiana, and currently lives in near-by Newburgh with his wife and daughter.