Saving and investing are both crucial for financial health. Yet investing is particularly important when it comes to mitigating longevity risk. In Part 2 of this three-part series about single women and longevity risk, we’ll delve into the significance of investing and explore how understanding risk and reward can empower women to become better investors.
Differentiating Saving and Investing
When it comes to personal finance, many conflate saving and investing. While both are crucial for financial stability, they serve different purposes.
Saving entails setting aside a portion of your income for near-term expenses or potential emergencies. In other words, your savings should be a safety net that’s liquid and risk-free.
Investing, however, implies allocating money to stocks, bonds, and other assets in anticipation of a potential return in the future. Despite the inherent risks, investing is an essential strategy for single women to increase wealth over time, so you don’t outlive your financial resources.
Understanding the Risk-Reward Relationship
While investing offers the potential for a higher return on your money, it’s also inherently riskier than saving. That’s why many women hold too much cash relative to their financial goals.
If you tend to be risk averse, you’re not alone. In fact, one Northwestern Mutual study found that in general, U.S. adults prefer to play it safe with their money than take risks.
However, understanding the risk-reward relationship is crucial for overcoming the confidence gap that many women experience as investors. Each investment carries a different level of risk, and effectively managing these risks is essential to achieve your financial goals.
Typically, investments with the potential for higher returns carry a higher degree of risk (although high risk doesn’t guarantee high returns). For example, higher-risk investments like individual stocks and equity funds generally offer the potential for higher returns over time. Conversely, lower-risk assets like savings accounts and short-term Treasury bonds tend to yield more modest returns.
Many women face the dilemma of whether to keep their money safe in a bank account or invest it for potential growth. Indeed, research suggests that men are generally more willing to take risks with their finances than women.
However, studies also indicate that as women gain confidence through education and experience, they become better investors. Moreover, women investors are more likely to exhibit traits such as reduced trading, increased patience, openness to advice, more diversified portfolios, and a healthy skepticism towards “hot” investments.
Ultimately, your financial goals determine the level of returns you need from your investments. Saving for a house down payment in the next few years, for example, might require safer investments with less risk. In contrast, saving for retirement that’s several decades away allows for higher-risk investments with the potential for more significant returns.
But you also need to weigh your return objectives against your comfort level with taking on risk. In this case, risk generally refers to the possibility of losing your money. Taking on more risk than you can tolerate can lead you to make rash investment decisions that impede your progress toward your financial goals.
Single Women and Investing: Mitigating Longevity Risk
To mitigate the risk of running out of money prematurely, women must embrace some investment risk. By profiling four different investors, we can illustrate the outcomes along the risk spectrum.
Assume the following savers/investors invest $50,000 for ten years and reinvest all interest and dividends.
- Investor #1 places her $50,000 in a savings account earning an average annual return of 1.5%. Her account grows to $57.815 in 10 years.
- Investor #2 places her $50,000 into a certificate of deposit (CD) with an annual yield of 3%. Her account grows to $67,196 in 10 years.
- Investor #3 places her $50,000 into a diversified portfolio* of 60% stocks and 40% bonds earning a 6% average annualized return. As a result, her account grows to $89,542 in 10 years.
- Investor #4 places her $50,000 into a diversified portfolio* of 100% stocks, and it earns a 9% average annualized return. As a result, her account grows to $129,687 in 10 years.
A Note on Volatility
While the 100% stock portfolio generates the highest outcome, it also experiences substantial fluctuations over the 10-year period. Meanwhile, the 60% stock/40% bond portfolio exhibits less volatility due to the lower risk associated with bonds.
Consider the following hypothetical annual return patterns for these two portfolios:
The graphs above illustrate how Investor #4 experiences larger swings in performance over the 10-year period by investing exclusively in stocks than Investor #3. In other words, the price of higher returns is generally increased volatility.
Thus, investors who are unable to weather the ups and downs of the stock market may need to sacrifice return potential to stay the course over time.
*Diversified portfolio returns were generated using Vanguard Total Market Funds, both U.S. and international.
Striking the Right Balance to Reach Your Financial Goals
The challenge for many independent women investors is understanding their risk tolerance in relation to their need for return.
For example, if Investor #1 doesn’t invest in stocks, will she reach her financial goals and manage longevity risk, or will she run out of money before the end of her life? On the other hand, does Investor #4 need to take quite so much risk, or can she beat longevity risk by investing in a less volatile portfolio?
These are the answers I seek when working with my female clients. Ultimately, my aim is to keep my clients invested for the long term to experience the magic of compounding returns and reach their financial goals.
In the third and final article in this blog series, we’ll look at the other side of the equation: minimizing longevity risk by managing your expenses in retirement.