Differing investment styles incur different amounts of risk.
Previously, I wrote a post that was centered around the efficient frontier in investing. That basically says that you can allocate your resources in a way that minimizes risk for the level of return you would like to achieve.
An example of this was how a portfolio of 75% bonds and 25% stocks had both a higher expected return and a lower expected risk than a portfolio of 100% bonds.
Similarly, if you move to 50/50 between stocks and bonds, you can still get quite good returns without adding terribly much risk.
Risk, in this sense, is mostly about ending up with less money over a long investment horizon.
Using asset allocation this way relies on other people doing the common (fear driven) investment tactic of selling stocks and buying bonds when stocks decline steeply (a bear market).
If you have 50/50 between them and a lot of other people sell stocks and buy bonds, you could expect your stock value to go down and your bond value to go up and perhaps your overall account value wouldn’t change much.
If you rebalance periodically, you would sell bonds (high) and buy stocks (low) and your account value still wouldn’t change much, but if the stock market did subsequently go up, your asset allocation would take more advantage of it.
Going back to the theme of the blog post, using asset allocation you can aim at a target end result.
Why might somebody want to do this?
The simplest reason is that they hate seeing their account balance go down.
The number one concern of pretty much everybody putting money into an investment is that they get out at least as much as they put in. Getting a high rate of return is somewhere farther down on the priority list.
You can pretty easily accomplish this by buying and holding nothing but federal government bonds.
Indeed, it’s not a terrible idea if you want to be 100% sure that you get out even more than you put in that you do just that.
By doing that, you open yourself up to other kinds of risks, like not having enough money at the end of your retirement horizon.
If you wanted to have 100% safety and still not have too little money at the end of the retirement horizon, what can you do? Really the only thing to do here is to invest more money. If you just save a higher percentage of your income, then you can accomplish both goals.
In fact, the most reliable way to ensure that you have the amount of money you require at a later time is just to save more.
Saving twice as much money in a conservative way is much more likely to get you where you want to be long term than investing in a much riskier way and targeting a higher return is.
If you think you can retire fine by saving 7% in a 401k and having the employer chip in another 3% (7+3=10) and you just invest it all in stocks, you surely might. You may even have a pretty good chance. However, you would be much more likely to get there if you chipped in another 3% (10+3=13) and you went closer to a 60s/40b blend.
It would be a lot smoother of a ride too, which would greatly reduce the risk that you make some sort of bad decision that destroys the value of your account such as selling all your stocks after a steep decline.
If you instead saved 12% (12+3=15), you could go even farther in the safe direction, like 50/50 or even 40s/60b and be even more likely to succeed.
Every percent you give up now allows you to get where you want both more safely and more surely.
When you hear a personal finance guru telling you to max out your 401k (18,000 for 2016), this is the effect they are hoping for. They hope you are putting in so much that you can’t possibly fail to reach your retirement goals even if you choose the most horrible options inside the 401k.
I am not going to tell you that maximizing your 401k is a one way ticket to success nor am I going to suggest that you do it, but as far as tries go I think it’s a pretty good one based on how simple it is.
I would rather you be able to choose good options and that you understand the math behind what you are doing.
Once you understand what’s behind it, you might decide to max the 401k anyway. If so, that’s great.
TLDR Save a couple more percent and put it in a fixed income sorta investment. It makes a world of difference.