Make today the day you figure out your risky to not-so-risky ratio.
Whether you’re just starting out as an investor, mid-career, or already retired, I want you to calculate the risk level of your investment plan(s).
Much like assessing your risk tolerance for investing, it’s not hard or time-consuming, and you may be surprised at what you find. That’s especially true given the steep drop in the stock market lately.
Why do I insist on using this longer and more alliterative term? Risky to-not-so-risky ratio doesn’t roll off the tongue quite like stock to bond ratio does. Still, it is more descriptive and comprehensive given all the alternative investments available these days.
What’s your risky to not-so-risky ratio? Go to your custodian’s website(s) to find the current market value of your investments. Use your phone, a spreadsheet, or the back of a junk mail envelope to record the information. (It’s a simple calculation.)
Add up the dollar total of all your risky investments and divide it by your total account balance. That’s your risky percentage:
Then compute your not-so-risky percentage. Make sure the two percentages add up to 100:
A 95-5 ratio means 95% risky investments and 5% not-so-risky, while 0-100 means all not-so-risky investments. Once you discover your risky-to-not-so-risky ratio, how do you know it’s appropriate?
Time Horizon and Risk Tolerance
Use your time horizon and risk tolerance for investing to determine your ideal risky to not-so-risky ratios, not just for this year but for every remaining year of your plan. That’s the first step in creating a customized investment plan.
The longer your time horizon for investment, the more aggressive you want to be with your ratios. When I say more aggressive, I mean more towards the riskiest ratio of 100-0. This is true whether you’re a super-aggressive investor, a super-conservative one, or anywhere in between.
The shorter your time horizon for investment, the more conservative you want to be with your ratios, which means leaning more towards the most conservative ratio of 0-100. Again, this is true no matter what your risk tolerance.
Keep in mind that your time horizon for investment, the time between now and your goal’s fruition, is continually getting shorter, which is why your risky to not-so-risky ratio needs to be dynamic. It needs to change from more aggressive to less aggressive.
You’ll be making these changes at the very least once a year if you follow my advice. That’s when you’ll be making the necessary changes to not only rebalance and reassess but also move from a more aggressive stance to a more conservative one when your investment plan calls for it.
One Year or Less Goals
When your time horizon is one year or less, it’s time to get super-conservative. Maybe you’re saving for your emergency reserve fund, tuition, or a vacation, and your time horizon started as one year or less. Or your once longer-term goal’s investment plan is now down to its last year.
Either way, your risky to not-so-risky ratio should be 0-100 for that one-year term. If a bubble hits and you’re still investing on the risky side, that goal isn’t going to happen. That means you should be out of those risky investments completely and investing on the not-so-risky side exclusively. Assuming there’s no disbursement period, this is true regardless of your risk tolerance if you’re serious about goal attainment.
Short-Term Goals
Short-term goals include those that started with a time horizon of 2-4 years, as well as longer-term goals that have matured into short-term goals. More aggressive investors may still have some money on the risky side, but much less than earlier with the percentages decreasing each year. Again, assuming no disbursement period, more conservative investors may still favor a 0-100 risky to not-so-risky ratio during this time.
Longer-Term Goals
Longer-term goals with time horizons of 5 years and greater allow for achieving higher returns. Even conservative investors will want to get more aggressive and increase their risky percentages with these longer time periods, hoping any losses from bubbles will have time to recover. The longer your time horizon the higher you want your risky percentages to be.
Rather than changing your investment plan all at once from risky to not-so-risky, do it gradually over the life of the plan. This insulates you from risk even more and helps with a “soft landing” with less volatility.
Retirement Example
Let’s look at two investors with the same 20-year time horizon for retirement, one aggressive and one conservative. Because of their different risk tolerances, their risky to not-so-risky ratios won’t look the same. Both, however, never have a riskier plan next year than last year, and both decrease their risk along with their time horizon.
For investors with a projected retirement at age 65, investment year 1 would occur at age 45, investment year 2 is at age 46, etc….
College Saving Example
Once again let’s look at 2 investors, one conservative and one aggressive, who are now faced with a college savings goal and a 10-year time horizon. In this example, year 10 represents your student’s senior year in high school:
Varying Disbursement Periods
I assumed a 4-year disbursement period in my college savings example, which is why the percentages are much less risky at the goal’s fruition when compared to the retirement example, which assumes a 25-year disbursement period. Whether conservative or aggressive, you still need some risk in your retirement plan at the beginning of retirement. That risky money is invested for your latter years of retirement where a long time horizon for investment still exists.
Once you are near retirement age, or by the time your son or daughter nears high school graduation for the college savings goal, be sure to fill in the risky to not-so-risky percentages, as well as the dynamic diversification, for the disbursement years too. Use the same logic you’ve been using, and make sure money is not only withdrawn from the not-so-risky side, but from the least risky of your not-so-risky investments.
Different Degrees of Risk
Be warned that there are different degrees of risk on both sides of the risky to not-so-risky ratio. As an example, crypto is way more volatile and riskier than an indexed large-cap value stock fund, and an FDIC-insured high yield savings account is much safer than a 15-year treasury note.
Once your risky to not-so-risky ratios are set, it’s important to build dynamic diversification into your plan, which is the last of my three risk management strategies. Diversification will help manage your risk even more.
Invest Tax Advantaged
What’s been the number one way to successfully build wealth over your working years? Investing in a 401(k)-type plan with an employer match. That’s a fact.
What’s the next best way? Investing in alternative tax-advantaged accounts. Even though these other accounts may not have a match, they’re also highly effective, much more so than a regular taxable brokerage account.
That’s why I’m so adamant about investing in tax-advantaged accounts. Take a Roth IRA and a 529 Plan as examples. Investing for retirement in a Roth IRA and for college savings in a 529 plan, like in the above two examples, would greatly enhance your after-tax rate of return. Why? Earnings (interest, dividends, and capital gains) in these accounts accrue tax free!