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Millennials should brace for a 'bucket of cold water' when it comes to their investments

Michael Ledford | Twenty20

The last decade has brought a charging bull market that doesn't seem to be losing steam. But that may have created unrealistic expectations among millennials that markets will never go down and that investing isn't that risky.

At least, that's one of the biggest concerns plaguing David Lafferty, senior vice president and chief market strategist at Natixis Investment Managers, heading into next year. Millennials, typically defined as those 23 to 38, "don't have any clue" about risk, he says.

"I think there's a bucket of cold water coming in the face at some point — I don't know what will cause it and I don't know when it will happen, but I worry that we're not ready for it when it does happen," he said during a press briefing last week.

How the investing environment shapes perceptions

The past few years have created an almost perfect environment for millennials to discount the risks they're taking when it comes to investing, Lafferty says.

Perhaps the biggest factor is that most millennials are too young to have ever experienced a sustained bear market where the value of stocks falls more than 20%. Since the financial crisis ended in March 2009, the markets have returned 17.8% annualized returns. Meanwhile, central banks, such as the U.S. Federal Reserve, have kept interest rates low during the same period.

Those circumstances have pushed many investors, especially millennials, into portfolios that are heavily concentrated in stocks, as opposed to the less risky bonds that just aren't paying these days.

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The problem with a stock-heavy approach is that at some point, the stock market will experience a sustained downturn. There's been some volatility in recent years, but Lafferty says it's been easy for investors to say they'll ride out a 10% or 12% drop. And many times that drop was short-lived. However, it will likely become much more difficult to watch their portfolio tank when the market drops 20% for a sustained period.

"I wonder if we're creating a class or generation of investors who haven't seen a bear market and don't think one can exist," Lafferty says. "I almost want to use the term snowflake — it feels to me that there's a little snowflakiness out there."

The rise of automated investing isn't helping

Investing apps and so-called robo-advisors that automatically invest and manage your money have grown in popularity in recent years. About 30% of millennials who say they invest use a robo-advisor to do so, according to a recent survey of U.S. adults 18 to 35.

But Lafferty says while these companies can make investing simple, they can also make it so investors, particularly millennials, don't know exactly how they're invested. And if they're not paying close attention, they could end up investing their money in far riskier strategies than they are truly comfortable with.

Betterment, for example, recommends a retirement-focused portfolio of 90% stocks and 10% bonds for a 30-year-old with a $50,000 income. Vanguard rates its similar 90/10 portfolio as having a risk potential of four out of five, with five being the highest risk category.

A low-risk portfolio is considered to have up to 40% in stocks, while a moderate risk is a portfolio with 40% to 60% invested in the market. Portfolios with more than 70% invested in stocks are generally considered high-risk.

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However, other robo services provide a more balanced portfolio. Fidelity Go recommends a portfolio of 70% stocks and 30% bonds for a similarly situated potential investor who responded their risk tolerance was a 5 on a scale of 1 to 10. Meanwhile, Schwab's Intelligent Portfolio product recommends investing 65% in stocks, 24.5% in bonds, 2% in commodities and about 8.5% in cash for a millennial saving for retirement and moderately aggressive.

Robo-advisors are not a bad way to invest, but millennials do need to understand how these companies are handling their money. When it comes to retirement accounts, you can ensure you always have an on-track, diversified portfolio by buying something called a target-date fund. These funds are designed as long-term investments with moderate risk and typically become more conservative as you approach retirement.

Not everyone is jumping all-in on stocks

About 27% of millennials are currently using stock market investments to build their wealth, according to a survey by MagnifyMoney. About 31% noted they were also saving for retirement, which may include investments in stocks.

Of course, not everyone is enamored with investing in the market. Over half of Americans say they are not participating in the stock market, according to a poll from MetLife of over 8,000 U.S. adults over 18. The survey finds that age is definitely a factor: 68% of Gen Z (ages 18 to 24) and 55% of millennials (defined here as ages 25 to 34) are opting out.

There's a problem with this approach as well. When it comes to building long-term wealth, saving alone typically isn't enough. The solution is to invest, but invest at a level where you're actually comfortable with all the potential outcomes.

That balanced approach may come naturally as millennials get older. Studies show that as people age, they naturally tend to think more about risk, in part because they have more assets and therefore more to lose. When you don't have any money to lose, it's perhaps easier to take on more risk. It's worth noting that most millennials are no longer college students and recent grads.

It's far from a sure thing that millennials will continue to be heavily allocated toward stocks. As they age and their assets grow, they may find that a less risky portfolio makes sense for them. "They may get there, I just think it's going to take longer to get there," Lafferty concedes, but adds that unfortunately for some, that lesson may happen after the market turns nasty.

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