Risk Aversion And Loss Aversion — Two Keys To Retirement Saving
When it comes to retirement planning, risk must always be carefully weighed. How much are you willing to — or should — risk in order to get the returns you need for a healthy retirement? The answer to this question varies due to many factors. It also changes as you get closer to retirement. Keys to finding the right risk level for you personally is understanding both risk aversion and loss aversion. Here's what every saver should know.
What Is Your Risk Aversion?
Risk aversion is the point at which your reaction changes when losing value in an investment. If the stock market or an individual investment's value drops 10%, 20%, or 30%, what is your reaction? Do you want to take out your money to preserve what's left? Do you take a long-term viewpoint and wait for the market to rise again? Or do you buy more investments, figuring that they're on sale now?
The amount of risk you are comfortable with — and that which you can reasonably accept — is your level of risk aversion.
What Is Loss Aversion?
Loss aversion sounds similar, but it focuses more on the preservation of the capital. Would you be more upset at losing 10% of the value of your asset or missing out on 10% gains? If it's the former, you are more loss-averse than risk-averse. This limits rewards but protects savings.
What Is the Relationship Between Them?
For retirement planners, a balance must be found between risk aversion and portfolio growth. Young retirement savers need to take a long-term approach to their investments, nurturing less risk aversion in order to grow their balances. Too much loss aversion during the key investing years risks serious damage to your retirement nest egg.
However, as retirement grows close, risk aversion should naturally turn into loss aversion. Because you will need to start drawing on funds within five or ten years, preserving the value of capital is increasingly important. Too little loss aversion means you could end up withdrawing money during a downturn, minimizing your retirement capital. This is generally not a time to experiment, but rather a time to plan how to maximize withdrawals.
Where Can You Learn More?
Finding the right mix of risk aversion and loss aversion is key to retirement planning. And because it should change over time, it's never a one-and-done task. Start analyzing your portfolio for both risk and reward by meeting with a retirement planning service in your area today.