Picking up where we left off yesterday . . .

Several years ago, a brokerage firm promoted put and call options on futures as “limited risk” investments. Their reasoning was that you couldn’t lose more than 100%, while in a futures contract a total loss just begins to scratch the surface of the misery that can befall you. Even so, “losing everything,” as most people who bought these things did, is not what most people think of when they hear the term “limited risk.”

Defining “risk” is one of the trickiest and most important keys to good asset allocation. Most of us would consider an investment that will probably become worthless within a few weeks . . . risky. Probably the only thing less suitable for investment than options and futures is lottery tickets (sadly, the primary investment choice of the poorest 10% of the population: many of those who buy lottery tickets spend over $600 per year, yet claim they cannot afford to start a $50 per month mutual fund investment plan that could make them semi-millionaires over their working careers).

Here’s a helpful definition by Robert Jeffrey, the estimable Less Antman found in the Fall 1984 Journal of Portfolio Management:

“Risk Is the Probability of Not Having Sufficient Cash with Which to [Pay for] Something Important.”

This seems a more useful definition than:

“Risk Is the Possibility an Investment Will Drop Below What You Paid” (as most do at some point, at least for a while, unless you happen to have bought at a never-to-be-seen-again low).

So when you are considering the appropriate risk to take, you need to start by knowing when you need the money and how much you’ll need.

If you are saving to make a $20,000 down payment on a house in five years and have the ability to save $4,000 per year toward that goal, you need take no risk whatever.

On the other hand, if you save 20% of your income each year toward retirement for your entire working life, but get no growth, you will end up with enough to live on for only 8 years. Perhaps the riskiest thing you can do during those working years is take “no risk” with your retirement investments.

Rationally, the most important determination of your risk tolerance is your time horizon. On a daily basis, or even an annual basis, the stock market is a crapshoot. Over the long haul, much less so.

But that’s rationally. Neither the market nor its players are entirely rational. Which leads me back to yesterday’s column and the importance of starting where you are. If you have your entire 401(k) in a money market fund, you are too risk averse. But don’t switch it all into stocks tomorrow and then say you’re following my advice. The stock market works best if you’re patient. So you might consider switching a large portion of your 401(k) to stocks — but slowly, through dollar-cost-averaging. Direct your new 401(k) contributions to stocks, and gradually reallocate your existing funds, perhaps a third right away and then some more each quarter.

But, with a 401(k), you don’t necessarily want to put 100% into stock funds, even gradually. Don’t feel dumb if you have a portion — maybe 40%? — in some safe, high-yielding alternative.

In the first place, because the yield is sheltered from tax, 8% of cash income is just as good as 8% long-term appreciation. Either one will ultimately be taxed as ordinary income at withdrawal.

If the markets were incredibly low here and you were 26, I’d beg you to put your entire retirement plan in stocks. But it’s not, and you may only look 26, or be 26 in spirit (I am, myself, 14), so don’t feel dumb having a portion of this money in fixed income if that makes you more comfortable, or if you feel your time horizon is relatively short. (If you really are 26, consider putting 100% of your retirement money in broadly diversified low-expense stock funds, anyway — planning to do so consistently for decades. If the market drops, that’s great — you’ll be getting future shares on sale.)

In the second place, if you have enough income and discipline both to fully fund your retirement plan and to set aside some extra money, do your riskiest investing outside your retirement plan. Your long-term gains will be lightly taxed when you sell, and any losses you decide to harvest along the way will help reduce your current taxes.

OK. Retirement is not a small thing — with luck, you may be enjoying 30 or 40 years of it. But what about money for which you don’t have such a long-term time horizon?

Tomorrow: Where to put money you’ll need in 5 years.

 

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