This is the third installment in Pennywise's "Investing for Retirement" extravaganza, earlier pieces of which can be read here, and here.
Last month, Pennywise provided links to a number of online calculators that will approximate whether you are saving at a rate sufficient for a comfortable retirement. Such trial runs can prod you to save more—contributing, in the end, to peace of mind.
A somewhat less obvious benefit of disciplined saving—month in, month out—is "dollar-cost averaging." That term sounds harder to understand than it is. Simply put, it means that as you contribute money each month toward your retirement, you are buying into financial markets at varying points of entry. Sometimes stocks will be cheap, sometimes expensive. Same with bonds. But by making automatic, incremental purchases over time, as opposed to plunking down a big stack of cash at one moment, you iron out the market vacillations.
Pennywise believes in dollar-cost averaging but hasn't the faintest idea why it is called that. Why not, say, investment-cost averaging? It's not the cost of the dollar that is being averaged, is it? What other currency would they imagine us investing with? Renminbi?
Anyway, now you understand dollar-cost averaging enough to bandy the term about with an air of sophistication over the punch bowl at Professor Dimwaddle's obligatory annual holiday party. "You see," you can say, as you fork another pot sticker onto your plate, "I simply tune out the financial news. I dollar-cost average instead."
Once you commit to regularly saving for retirement, you face the more challenging question of how, precisely, to invest the money, a subject that will occupy numerous coming installments of Pennywise's unfolding retirement-investment series.
There are many ways to go about it, including having palm readings, buying whatever Jim Cramer is screaming about on CNBC, and picking up a magazine that promises to reveal "What to Do With $1,000 Now." But the real place to start is not with oracles. It is within. Take a psychological inventory. What are your capacity and tolerance for risk?
Risk refers to the chance that an investment will decline in value temporarily—or even permanently or totally, though that is highly unlikely if you are investing in broad-based mutual funds. Reward refers to the likely rate of return, whether through increased price or through payments an asset generates, such as dividends or rent. Balancing risk and reward in a way you can abide is critical for your ability to stick with your investment plan and achieve long-term success.
Let's consider two dimensions: risk capacity and risk tolerance.
Risk capacity. That term expresses your ability to withstand a shock to your retirement holdings based upon an objective analysis of your financial circumstances. What is the regularity of your income? Do you have job security? What is the extent of your emergency cash reserves? Do you have insurance, including disability insurance? Do other people depend upon you for their livelihoods? Gauge your risk capacity by assessing such criteria.
An intriguing model of that is offered by Moshe A. Milevsky, an associate professor of finance at York University. In Are You a Stock or a Bond? (2009), Milevsky advocates that we consider ourselves "human capital" based upon our lifetime earning power. If you have high job security and a stable income that doesn't rise or fall with the stock market, then you are a "bond." If, on the other hand, you have a less predictable income stream, then you are a "stock." A person who is a bond may take on more risk (and thus tilt toward stocks in retirement planning), whereas a person who is a stock should be more cautious (and thus tilt toward bonds and cash in their retirement accounts).
We could reduce humankind to a mere cash nexus in so many more ways, if we chose. One of Pennywise's offspring—they are abundant—saw me reading Milevsky's book one day and suggested that the title be changed to Are You a Stock, a Bond, or a Tuition Payment? Catchy. There may be hope for the next generation after all.
There are reasons to be cautious with the human-capital analogy, especially because it might lead you to take on too much retirement-asset risk. In an interview in Money magazine, Milevsky once revealed that as a tenured professor, making him a "bond," he felt emboldened to be 150 percent in equities—to take out margin loans, in other words, to amplify his stock purchases. The interview appeared in fall 2008, just before the floor dropped out of the stock market. Let's hope he was short the market (betting against it, as opposed to buying stocks), or the margin calls must have been painful, indeed.
Risk tolerance. This measures one's stomach for risk. Can you muster equanimity in the face of adversity? Do you have the kind of calm temperament that helps you ride out a 30-percent decline in portfolio value, as you tell yourself it will all bounce back, if given enough time? Or would you be likely to sell immediately, in hopes of stemming further declines—thereby locking in the depressed value?
Risk tolerance, in other words, is less about our objective financial circumstances (what risk capacity tries to gauge) than our subjective psychology. What's right for one person may not be for another, even if both have identical levels of risk capacity.
To test your own risk tolerance, check out the questionnaires offered by the likes of TIAA-CREF, MSN Money, the Edmond Financial Group, or Ohio's CollegeAdvantage, among others. They typically place you on a spectrum, determining whether you are "conservative," "moderate," or "aggressive," and recommending that you set asset allocations accordingly. (Those categories might sound a little like they have something to do with politics, but they do not; a conservative investor may very well be a left-wing radical, while a Fox News-watching conservative may very well be a cockily aggressive investor. In fact, a study might find those inversions normative.)
Questionnaires can be useful, but only to a point, because our perception of our risk tolerance is not always accurate. When markets are rising and everyday conversations are abuzz with brokerage triumphs, reward seems but a low-hanging fruit. People at such times tend to overlook risk. In times of downturns and uncertainty, conversely, many become excessively skittish. That phenomenon, which can lead one to buy when one should sell, and to sell when one should buy, goes by the benign name of market sentiment.
Even if you fit the profile of a conservative investor and wish to minimize loss, moreover, it does not follow that all of your money should go into conservative investments, such as certificates of deposit, FDIC-insured savings accounts, or Treasury bonds. Holding at least some allegedly more risky investments, such as stocks, alongside the conservative ones, will actually reduce the overall risk of your portfolio.
Pennywise advises against seeing yourself in polarities—aggressive, conservative—and instead suggests seeking the Aristotelian mean. (I'm talking investing, not necessarily politics; in politics, to quote Barry Goldwater, moderation in defense of virtue can be a vice.)
It is wiser for people of all risk tolerances to adopt a diversified, balanced investment strategy. The question to determine is not so much whether you are a conservative or aggressive investor, but in which direction to tilt the portfolio: toward caution and protection, or risk and reward?
Last month, Pennywise provided links to a number of online calculators that will approximate whether you are saving at a rate sufficient for a comfortable retirement. Such trial runs can prod you to save more—contributing, in the end, to peace of mind.
A somewhat less obvious benefit of disciplined saving—month in, month out—is "dollar-cost averaging." That term sounds harder to understand than it is. Simply put, it means that as you contribute money each month toward your retirement, you are buying into financial markets at varying points of entry. Sometimes stocks will be cheap, sometimes expensive. Same with bonds. But by making automatic, incremental purchases over time, as opposed to plunking down a big stack of cash at one moment, you iron out the market vacillations.
Pennywise believes in dollar-cost averaging but hasn't the faintest idea why it is called that. Why not, say, investment-cost averaging? It's not the cost of the dollar that is being averaged, is it? What other currency would they imagine us investing with? Renminbi?
Anyway, now you understand dollar-cost averaging enough to bandy the term about with an air of sophistication over the punch bowl at Professor Dimwaddle's obligatory annual holiday party. "You see," you can say, as you fork another pot sticker onto your plate, "I simply tune out the financial news. I dollar-cost average instead."
Once you commit to regularly saving for retirement, you face the more challenging question of how, precisely, to invest the money, a subject that will occupy numerous coming installments of Pennywise's unfolding retirement-investment series.
There are many ways to go about it, including having palm readings, buying whatever Jim Cramer is screaming about on CNBC, and picking up a magazine that promises to reveal "What to Do With $1,000 Now." But the real place to start is not with oracles. It is within. Take a psychological inventory. What are your capacity and tolerance for risk?
Risk refers to the chance that an investment will decline in value temporarily—or even permanently or totally, though that is highly unlikely if you are investing in broad-based mutual funds. Reward refers to the likely rate of return, whether through increased price or through payments an asset generates, such as dividends or rent. Balancing risk and reward in a way you can abide is critical for your ability to stick with your investment plan and achieve long-term success.
Let's consider two dimensions: risk capacity and risk tolerance.
Risk capacity. That term expresses your ability to withstand a shock to your retirement holdings based upon an objective analysis of your financial circumstances. What is the regularity of your income? Do you have job security? What is the extent of your emergency cash reserves? Do you have insurance, including disability insurance? Do other people depend upon you for their livelihoods? Gauge your risk capacity by assessing such criteria.
An intriguing model of that is offered by Moshe A. Milevsky, an associate professor of finance at York University. In Are You a Stock or a Bond? (2009), Milevsky advocates that we consider ourselves "human capital" based upon our lifetime earning power. If you have high job security and a stable income that doesn't rise or fall with the stock market, then you are a "bond." If, on the other hand, you have a less predictable income stream, then you are a "stock." A person who is a bond may take on more risk (and thus tilt toward stocks in retirement planning), whereas a person who is a stock should be more cautious (and thus tilt toward bonds and cash in their retirement accounts).
We could reduce humankind to a mere cash nexus in so many more ways, if we chose. One of Pennywise's offspring—they are abundant—saw me reading Milevsky's book one day and suggested that the title be changed to Are You a Stock, a Bond, or a Tuition Payment? Catchy. There may be hope for the next generation after all.
There are reasons to be cautious with the human-capital analogy, especially because it might lead you to take on too much retirement-asset risk. In an interview in Money magazine, Milevsky once revealed that as a tenured professor, making him a "bond," he felt emboldened to be 150 percent in equities—to take out margin loans, in other words, to amplify his stock purchases. The interview appeared in fall 2008, just before the floor dropped out of the stock market. Let's hope he was short the market (betting against it, as opposed to buying stocks), or the margin calls must have been painful, indeed.
Risk tolerance. This measures one's stomach for risk. Can you muster equanimity in the face of adversity? Do you have the kind of calm temperament that helps you ride out a 30-percent decline in portfolio value, as you tell yourself it will all bounce back, if given enough time? Or would you be likely to sell immediately, in hopes of stemming further declines—thereby locking in the depressed value?
Risk tolerance, in other words, is less about our objective financial circumstances (what risk capacity tries to gauge) than our subjective psychology. What's right for one person may not be for another, even if both have identical levels of risk capacity.
To test your own risk tolerance, check out the questionnaires offered by the likes of TIAA-CREF, MSN Money, the Edmond Financial Group, or Ohio's CollegeAdvantage, among others. They typically place you on a spectrum, determining whether you are "conservative," "moderate," or "aggressive," and recommending that you set asset allocations accordingly. (Those categories might sound a little like they have something to do with politics, but they do not; a conservative investor may very well be a left-wing radical, while a Fox News-watching conservative may very well be a cockily aggressive investor. In fact, a study might find those inversions normative.)
Questionnaires can be useful, but only to a point, because our perception of our risk tolerance is not always accurate. When markets are rising and everyday conversations are abuzz with brokerage triumphs, reward seems but a low-hanging fruit. People at such times tend to overlook risk. In times of downturns and uncertainty, conversely, many become excessively skittish. That phenomenon, which can lead one to buy when one should sell, and to sell when one should buy, goes by the benign name of market sentiment.
Even if you fit the profile of a conservative investor and wish to minimize loss, moreover, it does not follow that all of your money should go into conservative investments, such as certificates of deposit, FDIC-insured savings accounts, or Treasury bonds. Holding at least some allegedly more risky investments, such as stocks, alongside the conservative ones, will actually reduce the overall risk of your portfolio.
Pennywise advises against seeing yourself in polarities—aggressive, conservative—and instead suggests seeking the Aristotelian mean. (I'm talking investing, not necessarily politics; in politics, to quote Barry Goldwater, moderation in defense of virtue can be a vice.)
It is wiser for people of all risk tolerances to adopt a diversified, balanced investment strategy. The question to determine is not so much whether you are a conservative or aggressive investor, but in which direction to tilt the portfolio: toward caution and protection, or risk and reward?
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