A general principle in finance is that assets that yield greater return also carry higher risk (as measured here by volatility).  A long- term study[1] of various assets for the period 1926 – 2006 verifies this proposition.

With life expectancy on the rise, chances are you will survive into your retirement years.  Most investors recognize this fact and invest for the long term, usually through retirement accounts, such as IRA or 401K.  There are important differences between investing for retirement and other type of accounts.  The long time horizon is an obvious difference.  Another is the fact that all retirement accounts (regardless of one’s income) start small and grow not only by means of investment appreciation but also through annual contributions, as permitted by law.

Despite these facts many investors (and, many investment advisors) follow an essentially incorrect approach in managing their retirement investments.  The typical advice given to young investors is: since you have many years before retirement, you should invest aggressively in growth stocks or small cap stocks.  These stocks offer the most appreciation potential.  They carry high risk but over the long-term their fast growth will compensate for the occasional down years.

We are going to present a contrary (almost sacrilegious) opinion and advice: do not assume high risk in your retirement investment!

To clarify this position we begin by highlighting the difference between average return and average compound return.  For example, consider the two-year record of a mutual fund that gained 25% in the first year but lost 15% in the following year.  The two-year average return of this fund was: (25%-15%)/2 = 5%.  However, an investment of $1000 at the beginning of the first year would have grown to $1062.50 at the end of the second year, which is an annual compound return of only 3.1%.  When selecting a mutual fund do not consider its average return but its average compound return over the past 3-5 years.

The point is that when you experience an occasional annual loss, you not only lose assets, you also lose time.  Time has a special value when you consider the compounding of interest.  The advantage of deferred tax payments associated with retirement investment is also related to the factor of time and to the compounding of interest.

When considering investment over several years, this volatility amplifies the effect of a loss.  The common but mistaken assumption in such investments is that you are automatically being compensated for this risk when you invest for the long term.  But despite this “compensation” your annual compound return will be lower i.e., you do not gain even in the long-term when you attempt to get returns beyond a certain level.

Small accounts (like IRAs) are subject to the problem of gambler’s ruin.  This term refers to the possibility of being wiped out completely when engaging in a particularly risky investment (like derivatives).

On a more fundamental level you should understand that some rates of return are unrealistic in the long-run.  Yes, some commodities traders double their money in a given year, and some lucky people do win the lottery.  But these cases must go against the probabilities.  The wealth of the country or the world is limited.  More importantly, its rate of growth is also limited.  Some financial geniuses might achieve a long-term annual rate or growth of 25% but the rest of us have to settle for a rate of growth of 10%-15%.

However, even when aiming low, at a real growth rate of 10% or even less, everyone can retire wealthy.  A financial planner can provide you with the exact calculation as to how much you have to save in order to achieve a given income level in retirement.  There is a place for risky investments in an investor’s portfolio but diversification is absolutely essential.  In fact, many investors invest funds outside their retirement account and that is the appropriate place to engage in various speculations.  Only after your retirement account is established may you venture on some risky investments as opportunities present themselves.  Don’t risk breaking the fragile compound interest trajectory at which you retirement wealth is growing.