Take Fewer, Not More Risks with Your Money

image source: szlea via flickr

Financial people often tell you to take more risks, especially when you’re young. Why is that, and is the advice any good?

The usual reasons I hear to take risks early are (1) you can’t do it later (2) it’s easier to recover from failure. But by that logic, you should also eat artery-clogging foods and inject yourself with illegal drugs while you’re young. In fact, such logic can be used to justify virtually any reckless behavior.

I suspect most people fall for the financial version of Russian roulette because it’s sexy. There’s an allure in winning a crazy game. There’s an aura about having an obscene amount of money. There’s the complacency that more money means you won’t have to change unhealthy lifestyle habits. But what if you don’t win?

What most people don’t talk about is an alternate path to the top of the mountain. One that’s less risky and also less dependent on luck. I’d argue people who take this less traveled route are even happier, but that’s a conjecture based only on a handful of personal experiences.

Before I get to an anecdotal example, I want to discuss some of the reasons I believe in the path of fewer risks. My conclusion is based on some sound calculations, financial opinions, and academic research. I’ll proceed by dismantling some common opinions.

Myth: Young People Need to Invest Aggressively

You’ll hear this one very frequently. I recently read this advice from Erik Folgate. I like many of his articles, but I fear this statement in his article about 401(k) investments promotes the wrong idea:

You can afford to be aggressive with your investments when you are young, because you have plenty of time to ride out the waves of the stock market. You are in it for the long-term, so one bad year in the stock market isn’t a big deal to you.

The advice does not match the numbers. I discussed this issue in my article about the timing of returns where I calculated how timing affects investments.

Here’s a quick example to illustrate the idea. For one-time or “lump sum” investments, the timing of the return does not matter when you ignore taxes. If you lose 10 percent and then gain 20 percent, that’s the same as gaining 20 percent and then losing 10 percent. The order doesn’t matter.

In fact, the idea might not have any basis at all, according to a great article at The Personal Financier.

Now I will agree that longer investment time schedules and proximity to retirement suggest young people can afford to hold out during turbulent markets. And that brings me to the real reason someone might consider investing more aggressively—if the invested money is not needed for a long time.

In a 401(k) account, money is typically watermarked for retirement. In this specific example, younger workers are longer from retirement than older workers, so they might be able to withstand more risk. But that’s not true for young people who might need the cash for a financial or health emergency.

And speaking outside of 401(k) accounts, young people generally have very pressing financial demands. And that brings me to my next point about why risky investments at a young age might be a bad idea.

Myth: Young People Face Fewer Risks than Older Workers

It would seem a single city dweller has fewer risks than a couple in their thirties or forties with a growing family. Entry level employees are often described as care-free, perhaps because many don’t financially support dependents.

Such romanticism misses the facts. New graduates face incredible financial instability. I might lack the perspective to make such a bold statement, so let’s rely on Scott Burns, a registered investment adviser.

What does he say about people in their twenties? In his article criticizing target mutual funds, he explains:

In your twenties you should be more conservative with your investments because your career is uncertain and you are faced with a major series of expensive projects. Paying for education loans, getting married, buying a house, etc. So it’s better to take a bit less risk in your investments to support your mobility and career uncertainty.

Career mobility is as much a boon as career uncertainty is a risk. I know people sitting on some sizeable loans. I worry what would happen if they lost their jobs, lacked family support, and could not make rent. If you were in that situation, would you want to draw out stocks that have lost 50 percent of their value? What if you don’t have enough to cover basic needs?

You might not need to enter such high-risk games, if happiness–and not wealth–is your primary goal.

Myth: Winning Risky High-Stakes Games Will Make You Rich

Winning games of high-risk may make you wealthy, but I don’t think it will make you rich. For me, rich is about having a usable surplus. Often, the effort required to win games of high-risks is so damaging that one ends up mortgaging future pleasure. For evidence, consider how many unhappy celebrities there are.

For this discussion, I want to discuss some recent academic studies mentioned in Money Magazine and Science Daily concerning the topic of wealth and happiness (hat tip: Everyday PR).

The main researcher is Ed Diener of the University of Illinois, but there is also mention of Duke University study about finance and optimism.

These articles would make you believe that too much of happiness can be a bad thing for success. They would have you believe that really happy people are unrealistic and should be taking more risks to improve their wealth.

Here’s such an excerpt from the Science Daily article:

The data indicate that happiness may need to be moderated for success in some areas of life, such as income, conscientiousness and career, Diener said.

“The people in our study who are the most successful in terms of things like income are mildly happy most of the time,” he said.

The article reflects the American notion that career success is success in life. Why do perfectly happy people need to keep pushing their career and potentially sacrifice happiness along the way? They don’t—happiness is the most important, and perhaps only, measure that matters.

So perhaps happy people are not trying to change because they don’t need to. This idea is hinted in the Money article:

There are some circumstances in which the very happy have an edge. They’re more likely to be successful as volunteers, and they’re better at dating and at maintaining close friendships. All keys to life satisfaction, but not necessarily wealth boosters.

The study actually criticizes happy people that choose to maintain a high level of happiness. Only in America!

Personal Example

Some of the happiest people I know took a low-risk approach to live, and I’d like to share one example.

One person I know spent his life as a government employee. He now lives in a house overlooking the ocean in Pacifica, California. He is a handy person, and he spends his retired life helping neighbors fix and renovate their houses. His neighbors all love him for this. He told me that he’s sitting on more money than he needs. His advice to me: consider government work.

The lesson is that a stable, steady career path may not be for everyone, but it’s an option that shouldn’t be dismissed merely because it is low-risk.

In fact, when you have found happiness, your sole goal is to preserve it by reducing risk. That means things like income stability, insurance, quality of health become much more important than chasing the almighty dollar.

So you’ve heard my unconventional take on the topic. Now I want to hear yours to balance it out, so please share in the comments.

What’s your take on risk, age, and happiness?

This article is included in the Cavalcade of Risk at Colorado Health Insurance Insider