Over a long period of time, volatile investments like stocks and real estate can yield big returns. But you have to be comfortable dealing with big potential losses.
Jane writes in:
I think you’re giving bad advice to people when you tell them not to put everything in stocks or real estate when making a long-term investment. Over a long period like ten years or more, you simply can’t beat the returns there.
Long-term investing relies on several assumptions, two of which hinge very strongly on personal luck and personal behavior.
One, you’re not going to touch that balance for a very long time. The chance that you’ll touch that balance in any way over the next decade (at least) is very, very small. If there is a crisis in your life, you have other assets you can use to deal with that situation without touching your long-term investment.
Two, you are completely comfortable watching the balance of your investment drop through the floor every once in a while. It’s easy to feel good about an investment when you see it earn a 15% return over the course of a year. It’s a lot harder to feel good about it when you see a 40% drop over the course of a year.
The first issue can be resolved to a large extent through solid personal finance management. Pay off your debts, maintain an emergency fund, and you’ll go a long way toward heading off most of the crises that would interfere with your long-term investing.
The second one, however, is a bit trickier to handle.
During 2008, I witnessed several people I know make panicked moves with regards to their retirement savings and their own personal investments. They yanked their money out of stocks in the latter days of 2008, locking in enormous losses, and put their money into other investments.
With hindsight, this looks like a terribly bad decision. 2009 and 2012 were both stellar years for the stock market and stocks have regained every bit of ground that they lost in those years.
The problem is that, in the moment, it’s very hard to see that type of rebound when you’re watching your life savings dwindle away. You also don’t necessarily know how you’re going to react in that moment.
My perspective is that the key to the matter is what I call a “hardening” of one’s needs. When you’re young and retirement is a very long way off, a big loss isn’t that big of a deal. I watched 2008 flow through my retirement accounts and it didn’t seem disastrous.
However, if I watched 2008 from the perspective of my parents or my in-laws, it’s a very different picture. It’s scary because it’s much more immediate. While they may have still been outside of that ten year timeframe, a big retirement loss is much more urgent because their lives are beginning to move toward retirement.
So, what I suggest is that if you’ve reached a point where you know what your target “number” is and you know roughly when you need to reach it, you need to start moving into safer investments, even if the horizon is more than ten years off. The “firmer” the target date and target number are, regardless of the time until you reach that point, the more you need to move into safer investments like bonds and cash.
What if you need those “big gains” to reach your number? If that’s the case, then you need to look at saving more or else putting off your target date a little bit.
If you have a target date in mind and you’re gearing up your life to retire in that timeframe, a big stock market or real estate swoon becomes incredibly scary. Once that timeframe becomes pretty clear in your life, you’re making other life plans according to that timeline, and you see things progressing clearly toward that investment endpoint, you need to start preparing for it, even if it’s more than ten years out.
Don’t ride the giant roller coaster if you’re not in the right position to handle the big drops.
Again, personal finance isn’t about pure dollars and sense. It’s about managing your emotions, and it’s also about putting things in the broader context of your life. Keep that in mind with every single move you make.