To illustrate, let’s say you’re starting from scratch with a goal to become a millionaire within 20 years. If you plan around earning a market beating 15% per year, you might think investing $667.90 per month would be enough to get you there. If, on the other hand, you plan around a more modest 8%, you’d want to try to figure out a way to sock away closer to $1,697.73 per month.
In either case, if you hit your plan, you’ll be fine — but what happens if you aim for the 15% returns but only hit 8%? In that case, you’d wind up with only around $393,400 after 20 years — far short of your goal. If, on the other hand, you invested enough to reach your $1 million target with 8% returns but instead did reach that 15% goal, after 20 years, you’d wind up with a whopping $2.54 million.
That way, you weren’t counting on trouncing the market to wind up with a million-dollar nest egg, but if you did manage to do so, your rewards would be that much sweeter. In essence, by doing so, you’re putting luck on your side instead of relying on it just to hit your goal.
2. Spread out your risks appropriately
If all your money is tied up in one stock and the company behind that stock fails miserably, then your entire plan could very well be derailed. If, on the other hand, you spread your risks out evenly across 20 stocks, then it’s easier for your portfolio to absorb the loss of any one company. By kitchen table math, if the market returns around 10% per year, then the loss of one company in an evenly weighted 20-stock portfolio would cost about half a year’s worth of expected returns. That’s a much more manageable risk.