Have you run the numbers?

Trent at the Simple Dollar recently wrote a post sharing a question he received from a reader. Here’s what the reader asked:

I’m twenty eight years old and am now debt free. I’d like to start investing, but I have almost no tolerance for risk. I don’t mind not earning a great return because of this, but the thought of losing any of my investment makes me feel very uncomfortable. Any suggestions?

Many people would read this and commend the investor for being sufficiently self-aware to recognize a low level of risk tolerance. And on the one hand, I completely agree. It’s good to know ahead of time that a decline in your portfolio value is likely to impact you in a significant way emotionally.

Here’s my problem though: “I don’t mind not earning a great return because of this.” I’ve heard that exact sentiment voiced by friends/coworkers, and it seriously concerns me.

What worries me is that people seem to assume that “not earning a great return” simply means that they’ll never be fabulously wealthy. In reality, it likely means that retirement will be nearly impossible without a drastic downgrade in quality of living.

For example…

Let’s run the numbers for the above (28-year-old) investor, using the following best-case-scenario assumptions for a “no risk” investment plan:

• The investor, seeking low volatility, invests in Treasury Bonds, and earns an annual return of 5.5% over her lifetime. (They actually earned 5.2% from 1928-2008.)
• Inflation averages 3% over the investor’s lifetime. (It’s actually averaged 3.25% historically according to the U.S. Department of Labor.)
• Social Security will provide for 40% of her cost of living in retirement.
• The investor plans to retire at age 65, thereby giving her 37 years to accumulate the necessary capital.
• The investor’s cost of living is currently $40,000

How much will the investor need to accumulate in order to retire? Approximately $2.86 million. And at a 2.5% after-inflation rate of return, how much would she need to invest every year to get there in 37 years? Just over $25,000.

I think we can all agree that’s nearly impossible.

What about with a diversified portfolio?

In fact, even if we assume the investor was 50% in stocks and 50% in bonds, thereby earning a 7.13% annual return over the period (the average of the 5.2% earned by bonds and the 9.07% earned by stocks), she’d still need to be investing $10,495 each year. Not impossible, but certainly not easy for a person making $40,000.

In short, if you’re truly OK with the idea of not retiring, then “not earning a great return” might be just fine. If, however, you are planning to retire, it’s probably a good idea to look into owning stocks. 🙂