Low-Risk Investment Planning

The typical approach to investing can be broken down into two steps:

1. Make a list of all your financial goals.
2. Then, put together an investment plan that will give you the best chance of reaching those goals.

That’s always seemed pretty logical to me. To date, it’s the way I’ve approached my own investing. But I’m starting to ponder whether a different approach makes more sense.

Dreaming Big: A Good Idea?

In  step #1 above, we’re usually encouraged to dream big. List everything you’d like to be able to do — retire at 50, travel the world, own a second home, send your kids to Ivy League schools, etc.

A natural consequence of dreaming big is that, in many cases, the only way to reach such ambitious goals is to earn high returns. And the only way to earn those high returns is to invest via higher-risk investments.

Unfortunately, high-risk investments don’t always pan out. That’s why they’re high-risk.

In their book Spend Till the End, Laurence Kotlikoff and Scott Burns argue that the reason we’re encouraged to dream big is simply that the financial services industry is looking out for its own interests rather than ours. They make more money when we take on more risk in hopes of higher returns.

• When we trade stocks frequently or invest via actively managed mutual funds, they make money.
• They don’t make a lot of money when we invest via low-cost Treasury bond funds. (And they make even less if we buy TIPS or other Treasury bonds directly.)

Switching the Process

What if we did things in the other order? What if we approached investing by figuring out what returns we could reliably earn with low-risk investments, then we set goals based on that?

Retiring at 50 would be ruled out for nearly everyone. As would the possibility of a second home. And the Ivy League education for your kids would probably be ruled out too.

But you know what else would be ruled out? The possibility of going broke in your seventies with another decade (or three!) left to live simply because your high-risk investments didn’t perform as well as you’d hoped.

To be clear: I’m not trying to make the case that nobody should take on any risk in their portfolio. If you’re comfortable with the ramifications of risky investments, then by all means, go ahead and use them.

Rather, my point is that, instead of starting with goals and working backward to the portfolio, perhaps it makes sense to start with the portfolio. Determine how much risk you’re comfortable taking, assess what level of returns you can expect based on that level of risk, and then develop your goals based on that information.