Financial planning is very often thought of in the light of RISK=REWARD
Financial planning is very often thought of in the light of risk=reward with the idea that the more risk an individual takes on, the more upside reward is available.
The example could be that the more aggressive a person is investing their 401(k) (more exposure to stocks) the greater the upside potential is and based on that upside potential certain calculations can be made to see how much money needs to be saved to reach future set goals.
Our example takes Nurse Jane who is 45 years old and she would like to retire at 65.
If Nurse Jane is told that she can, based on historical stock market rates, expect to earn 5% on average she will be able to do backwards calculation to see how much she would have to save every year in order to get to her desired future dollar amount.
If she is told that she can invest more aggressively and thereby earn a higher rate of return her new calculations will not tell her that she can put less aside and still reach the same future dollar amount.
Let’s look at a specific dollar example: If Jane needs $1,000,000 in 20 years and she expects a 5% rate of return she would have to save about $28,000 every year.
If on the other hand she is told that she may be able to earn an 8% annual rate of return she would only have put aside about $20,000 a year.
What would you do?
Put aside 20,000 or put aside 28,000 if the future projected result would be the same?
Most people will put aside less and hope for the higher rate of return.
This is where risk=reward comes back and potentially ruins many retirements, ruins may college plans and creates a hope that never happens.
By deciding to save the lower amount this individual has taken not only additional risk in the market but has also taken on additional risk by saving less and hoping for something that is not in any form guaranteed to be there.
By saving less, a lot more pressure is being put on timing retirement perfect so that there is no major correction in the years right before retirement.
The theory of risk reward can backfire and can stop you from retiring.
In case the rate of return you hoped for does not occur, in case you are not fully employed every year going forward, in case there are some other unexpected life events that takes away your time or money you probably will not get to where you were hoping you would be financially.
The solution: TAKE CONTROL
o Save 15-20% of your income
o Do not plan around a future hypothetical target
o Do not save based on a hypothetical rate of return that may or may not happen
o Prepare for unexpected life events
o Make sure you have appropriate protection in place around your life
- Invest based on your time horizon and your risk profile
Written by CreativeNurse Team
2016-25240 Exp. 6/18