Risk Happens

While perusing the Bogleheads discussion forum, I recently ran across an interesting discussion about ways of taking on additional risk to increase expected returns. In short, the discussion-starter says that he’s socking away as much as he can in a fairly typical three-fund portfolio but that the expected 7-8% returns won’t get him to where he needs to be.

In hopes of increasing his odds of making it to the promised land, he wants to take on more risk but isn’t sure of the best way to do this. Suggestions included simply increasing his equity exposure at the expense of bonds or tilting his existing equity holdings toward small cap, value, and emerging markets.

Of course, there were also calls to earn more money (thereby enabling increased savings), work to a later age (increasing the nest egg and decreasing the years in retirement), or reduce his expected living standard (thereby decreasing the cost of living both now and in retirement).

Honestly, I have to say that I fall in with the latter group. One of the big things that people (especially younger investors) fail to recognize is that you can’t simply declare that you’re risk tolerant, then crank up the risk knob and enjoy fatter returns.

There’s a reason that increased risk is associated with increased rewards. For lack of a better phrase…

Sometimes risk happens.

And it can happen at the worst possible time. Yes, higher risk investments are typically associated with higher average rates of return. But we’re talking long-term averages here. And those higher averages come with higher (sometimes much higher) variances.

In other words, in the pursuit of higher returns, you could end up with much (much!) lower returns. Risk shouldn’t be viewed as some nebulous, intangible thing that you simply have to tolerate in order to crank up your returns.

If you have a long enough timeframe then yes, you can (hopefully) ride out the down times in hopes that things will recover before it’s too late. But there’s a very real possibility that things could turn out worse than expected so you need to keep that in mind when tweaking your asset allocation.

Look at it this way… If you can’t afford retirement on your current path, do you really want to stretch for higher returns? Sure, a fatter return could get you to where you need to be, but you could also wind up in an even worse position if things don’t go your way.