If you’ve ever lost sleep worrying that a dramatic event might derail your finances—your brokerage failing à la Lehman Brothers, for example, or the stock market tumbling as a result of a technical glitch—you might be focused on the wrong risks.
For one, there are robust protections for individual investors in the unlikely event a bank or brokerage goes under, and many so-called black swan events caused only minor market disruptions.
More important, it’s the subtler pitfalls—the ones that can creep up on you over time—that are really worth guarding against, says Mark Riepe, senior vice president at the Schwab Center for Financial Research. “It’s one thing to take a calculated risk,” he says. “It’s another to get blindsided by the sorts of day-to-day risks to which we’re all susceptible.”
With that in mind, here are five hazards investors too often neglect.
When it comes to retirement, doing nothing may be the biggest risk of all. The longer you delay establishing goals and putting a savings plan in motion, the less time you have to benefit from compounding, or earning returns on your returns. “And if you wait too long,” Mark says, “it can become almost impossible to catch up.”
Suppose a hypothetical 25-year-old invested just $250 a month until retiring at age 65. At the end of four decades, assuming an annualized return of 6%, this early and consistent saver would have accumulated nearly half a million dollars—more than three-quarters of it attributable to compounding (see “The snowball effect,” below).
If that person had delayed saving until age 35, by comparison, he or she would have had to save nearly twice as much a month to achieve the same net savings.
The snowball effect
Investing just $250/month for 40 years would earn you nearly $375,000 in compound returns.
Source: Schwab Center for Financial Research. This hypothetical example is for illustrative purposes only and is not intended to represent a specific investment product. It assumes an annualized return of 6% and that dividends and interest were reinvested, and does not reflect the effects of fees or taxes.
2. Unrealistic expectations
Even after you’ve set goals and established healthy savings habits, you still risk coming up short in retirement if your expectations for returns are unreasonably high. Although it’s impossible to say for certain how your investments will fare over time, there’s broad consensus about what to expect in the coming decade.
Charles Schwab Investment Advisory, for example, expects U.S. large-cap stocks to return an average of 6.7% annually from 2017 through 2026, counting dividends and share-price appreciation, and investment-grade bonds to return just 3.1%. That’s one-third and one-half lower, respectively, than the averages experienced during the past half century.
For proof of why this matters, look no further than the headlines about states facing funding shortfalls in their public-employee pensions. In almost every instance, politicians were overly optimistic about the returns fund managers could achieve.
“With almost all of these underfunded pension plans, we see a dramatic example of what happens when you don’t save enough—and fool yourself into thinking that the market will bail you out with an unrealistic rate of return,” Mark says.
3. Neglected portfolio
A lot of risks needlessly pile up if you don’t update your plan and portfolio from time to time. An approach that made sense for a married couple with no kids may be all wrong once the family expands, for example, and an aggressive investment strategy when you’re 50 might be downright detrimental a decade later. Even the most forward-looking portfolio can drift from its goals as some asset classes stagnate while others surge.
“There’s no such thing as one and done,” Mark says. “Your situation changes, the world changes—and your portfolio may need to change with it. You should review absolutely everything at least once a year.”
Inflation in the United States has been at historically low levels for the better part of a decade. Indeed, “there’s now an entire generation that has little or no experience dealing with the risks associated with inflation,” Mark says. That said, you shouldn’t ignore the possibility that the purchasing power of your long-term investments might be badly eroded by a rising cost of living, particularly as it compounds over time.
Inflation is a risk for retirees, in particular, because an outsize percentage of their spending goes to health care, which has seen much steeper price increases relative to the other goods and services that make up the Consumer Price Index (CPI).
One way to combat this risk is to set a higher retirement-savings goal to prepare for this eventuality. Another is to recalibrate your investing approach—by shortening the duration of your bonds so their prices aren’t as vulnerable to the rising interest rates that often accompany inflation, for example.
5. Lack of learning
Research has shown that those with even a basic level of financial literacy—including an understanding of compounding, diversification and inflation—are more likely to achieve their retirement goals than those without.1 “There’s a risk in not taking the time to understand key financial concepts,” Mark says. “Conversely, there’s an opportunity for those who do make the effort.” (See “Back to school,” below.)
The risk is especially acute for young adults, who often enter the workforce with a limited understanding of financial fundamentals. “Time is a young person’s greatest advantage,” Mark says, “but they need to know why and how to leverage it.”
Mark suggests we all take the time to educate those just starting out. “Teach them the basics and introduce them to your go-to resources,” he says. “Often, it’s just a matter of pointing them in the right direction.”
1Annamaria Lusardi and Olivia S. Mitchell, Financial Literacy and Planning: Implications for Retirement Wellbeing, National Bureau of Economic Research, 05/2011.