How do you balance risk vs reward?

How do you balance risk versus reward on your investments? Understanding and managing your risks is one of the real keys to long-term investment success.

Retirement planning especially on the investments and income and really all of retirement planning is all about managing risk. So what are the risks to your income over time? It could be running out of money. It could be inflation. Healthcare. But what are the risks and managing the risks on the investments is so important.

I talk about risk versus reward all the time. Nobody wants to lose money, but we want to make money so we have to balance those two things. And there are two questions we have to ask how much risk are we willing to take, which is very much a function of how much we’re willing to lose when inevitably we have bad markets and how much risk can we afford to take or do we have to take?

For most people in retirement I talk to, it is more how much can you afford, not how much can you take. They are taking too much risk when you get down to it and look at potential volatility in the portfolio. We just have to remember that bear markets, market corrections, volatility are expected in the markets.

When we had a sharp market correction in January and early February, that shouldn’t have surprised us. Those things happen all the time in the markets. We don’t know when and why, but we know they’re going to happen. You have to have a plan to deal with that and how you mitigate that risk. There are a lot of ways to do that. I’ll give you the top two.

One is to have safe money. Safe money doesn’t lose anything but you have to have the right kind of safe money. To me safe money is money that guarantees principle, or at least, it’s extremely stable. Most bond mutual funds I would not put in the safe category, because they’re not guaranteed to recover losses. They go in the risk bucket.

Two is diversification. Most people do not diversify properly. If you have a traditional mix of 60-40 stocks and bonds and your 40 percent is overwhelming U.S. bonds, which they usually are, your portfolio is really still going up and down with the stock market. Ninety percent of your long-term success in investing is driven by your asset allocation, not the actual product selection. What mutual fund or index fund or what you buy inside those funds and how are you balance it drives success. Most portfolios are betting on the market. How do you have a mix that doesn’t just bet on the stock market? If you do want to bet on the stock market, understand you’re willing to take those risks in order to generate the potential rewards.

So balancing risk versus reward, asking yourself how much you’re willing to lose becomes critical in long-term successful retirement planning.