Age does matter in risk management

Your personality plays a big role when it comes to how you invest your money, but when it comes to how you manage your investment risk, age should play that big role. Understanding the longer-term nature of the various assets you can invest in, is important when you construct your investment plan. As a general rule, investing in cash will provide you with a lower, yet stable return, and investing in equities will provide you with a higher, yet volatile return. The obvious result is that a more risk-averse person will prefer to invest in cash and a person that is more risk-tolerant will choose equities. These personality-driven investment choices can, however, have a dramatic impact on your investment performance over time.

When you are young and just starting out on your investment journey, you have very little. If you are a risk-averse investor, it will be very tempting to invest the little you have in cash, because losing it will be painful. But that will be the wrong choice. If the money you are putting away is truly for retirement purposes, you should invest it in something that will give you the highest return, and risk should play second fiddle. Let us, for the sake of argument, consider only equities as our high-risk investment option; and leave out the other high-risk options like investing in your education, your own business or property. The argument for investing in equities when you are young – even while accepting the possibility that you can lose it all – stems from the fact that even if you do lose it all, time is on your side to make it all back. It is also highly unlikely that you will lose it all permanently in a well-diversified equity portfolio. The upside of investing in a portfolio of equities, is the likelihood that over time, the compounding effect of the higher return you get, will obliterate any return you would have received in cash.

However, when you reach the age where your high-earning years are behind you and your investment portfolio becomes your main provider of monthly income, you have to make the switch to wealth preservation, rather than wealth creation. Chasing the highest return at any cost during this stage of your life can undo all the good you and your investments have done over your life and leave you destitute. Equities are unpredictable and even fantastic companies can stay depressed for long periods of time. The best thing to do during the time of your life when you rely on your investments for income, is to increase your diversification and provide cash liquidity for longer periods, so that shocks in the equity markets can be tolerated.

In summary, we can say that there are life stages to investing. You have to start early, and focus on getting rid of any debt. You have to concentrate on equities in your high-earning years and gradually increase the cash or cash equivalent portion of your portfolio as you grow older. Once you rely completely on your investments for your income needs, your portfolio should be well-diversified and sufficient cash should be available for long periods of market instability.

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