Investment Portfolio Analysis: Stocks, Risk & Retirement

Introduction: Social Security and Self-Directed Retirement Planning

Investing money for the future is one of the key components of creating a secure retirement. While many Americans do not plan beyond a company retirement plan and Social Security retirement benefits, research shows that when a person takes an active role in retirement planning, they are more likely to create a future that supports their standard of living after they have stopped working.

Regarding the Social Security Administration and the SSI benefit program, at its inception during the 1930s the system was based on one beneficiary receiving payments from over 20 contributors. As the population shifted toward longer lives, current estimates place one beneficiary receiving payments based on 8 workers paying into the system. In the near future, as the baby boom generation retires and Generation X and Generation Y workers pay into the system, estimates demonstrate that one beneficiary will be supported by only 2 to 3 workers. "After the release of the 1989 Trustees Report, at least one authority declared that the picture on Social Security's financial health was a rosy one for the elderly, but a dim one for the young." (Robertson, 1990)

During recent political campaigns, discussion arose regarding a "lock box" for Social Security trust fund payments. Unfortunately, the government disregarded this suggestion, as it has for generations. The Social Security trust fund does not function as a genuine trust fund — it is composed of government-issued IOUs to beneficiaries, and payments are drawn not from accumulated reserves but from current contributors. This arrangement has placed the Social Security system in jeopardy, thereby increasing the importance of individual, personal retirement accounts.

Recognizing that private citizens are often better positioned to save money than the government, the Reagan administration changed many retirement laws and created new retirement vehicles. The American worker was thus encouraged to pursue self-funded retirement. IRA accounts, Roth IRA accounts, Keogh plans, and 401(k) investment vehicles are among the creative and effective means available to plan for the future.

Investing for the future, and the investment vehicle chosen to fund a happy retirement, depend greatly on the attitude and risk tolerance of the investor. Individual investments should reflect the personal comfort level and the financial goals of the investor. In the investment market, the greater the risk, the greater the potential reward — and equally, the greater the potential loss.

Risk, Reward, and Risk Tolerance

This risk-reward relationship is not a smooth, linear curve, nor do the levels carry any specific monetary values. The representation exists to demonstrate one of the most important aspects of investing: when an investment carries a higher risk factor and is more speculative in nature, the potential for return is greater than an investment with a lower risk profile. The same relationship holds in reverse — the higher the level of risk, the greater the potential for unexpected loss. For this reason, every investor must determine two key factors before entering the marketplace:

1. An investor must determine whether he or she is investing for long-term or short-term gains. Knowing how soon the money will be needed helps determine the level of risk the investor can safely accept — often called the "event horizon."

2. The investor must decide whether he or she is comfortable with the possibility that the invested money could lose value over time. This is a personal preference that operates within the scope of the investment event horizon. Every person carries their own personal risk tolerance, and should select investment vehicles that allow confidence rather than worry. (Bernstein and Clarfeld, 1997)

For this investment portfolio, the event horizon is long-term. As a younger worker with solid earning potential, the objective is long-term growth that will create significant value for retirement 25 to 30 years into the future. For these reasons, short-term appreciation and depreciation in portfolio value is an acceptable trade-off for the prospect of significant long-term accumulation.

Diversification as a Risk-Minimization Strategy

In order to further reduce the threat of significant loss, a strategy of portfolio diversification is employed. Different sectors of the market tend to move together. For example, if a recession affected the financial sector of the U.S. economy, all companies within that sector would be similarly impacted. In the aftermath of September 11, 2001, insurance companies suffered significant losses in value as a group in the months immediately following the crisis. Similarly, when the technology boom of 1998 and 1999 suddenly ended, tech stocks across the entire NASDAQ exchange collapsed, with the index dropping nearly 3,000 points over the course of a few quarters.

In order to protect the individual investor from significant losses of this kind, an investor should select stocks across different industries. When one stock is adversely affected by sector-specific conditions, the other holdings in the portfolio are less likely to be affected in the same manner or to the same extent. (Bolten, 2000)

For these reasons, the investment portfolio is composed of the following five stocks: