Your principal is the base amount that you put into an investment. During retirement, because you are no longer adding money to this base, the security of your principal becomes more important. This is why you want to understand the investment choices available to you in terms of the amount of risk they expose you to versus the amount of reward that they can offer.
There are many different ways to invest your money in order to earn a return on your principal. Market investments are one of the most popular ways and they rely on two ingredients to generate their rewards: Risk and Time Horizon.
Let’s define these terms:
- Risk is the danger or probability of loss.
- Time Horizon refers to the expected number of years or decades that you will hold the investment.
- Reward refers to the potential for a greater return on your money.
Generally speaking, all market investments involve some degree of risk. The longer your time horizon, the more likely the ups and downs of the market will even out and a reward will be realized.
What happens during retirement is that your timeline changes. Instead of being able to leave the money alone for 30 or so years, you have to start taking some of it out for income. This means that some of your money will be in your accounts for a much shorter period of time, and as such that money is exposed to greater risk. This is what makes many investors uneasy as the time of retirement approaches. Intuitively, they realize a shift happening in their risk tolerance.
Risk tolerance refers to an investor’s ability to hold on during times of loss in order to realize the reward of an even bigger return. Financial advisors and brokers often use descriptors to rate a person’s risk tolerance, and sometimes the investment funds themselves are also named to reflect risk tolerance:
- Aggressive: signifies a high-risk tolerance. This investor or investment is more likely to risk losing more money in order to get more reward.
- Conservative: signifies low-risk tolerance. This investor or investment is more likely to preserve a portion of the money in strategies that offer lower return in exchange for more certainty.
- Moderate: signifies a medium-risk tolerance. This investor or investment is more likely to risk some money while also preserving an equal amount so that neither too much nor too little is gained or lost.
TIP: Just because an investment uses words like “conservative” and “moderate” doesn’t mean that your principal is protected. All market investments, even bonds, have some degree of risk. If protection from loss is important to you, ask your advisor: does this investment have any principal guarantees?
One of the traditional rules for balancing risk and reward during retirement is The Rule of 100. This rule states that individuals should hold a percentage of market investments equal to 100 minus their age. For example, if you are 65 years of age, then 35 percent of your portfolio could be in market correlated investments that carry risk, and 65 percent could be in safer investments that protect your principal.
There are other ways to earn a return on your money that don’t involve market investments. If you would like to know more about your investment options during retirement, please feel free to contact us and one of our financial experts will get back to you.