Sunday, February 6, 2011

Pick Your Poison (You Can’t Avoid Risk)

No matter how you choose to save and invest, you are taking some type of risk. This is obvious if you are investing in stocks (including stock mutual funds), but it may be less obvious if you are simply keeping all of your money in a savings account. Stocks are clearly risky, since values can fluctuate dramatically. What you may need to think a bit more about is that if you keep all of your money in a savings account, you are taking the very real risk that after taxes and inflation, your savings will lose purchasing power over the years. One of the most important steps in developing an investment plan is to think clearly about risk, and decide what types of risks and how much of each type of risk it is appropriate for you to take.

Our brains have evolved to react strongly to quick dramatic changes, but not so strongly to slow changes over a long time. This causes us to be much more fearful of sudden changes in the value of our investments than the slow erosion of purchasing power over many years--due to inflation and taxes (and low returns). Historically, a broadly diversified portfolio of stocks (now easily obtained with one or two index mutual funds) has usually provided much higher long-term returns than bonds or cash, but with inevitable, dramatic ups and downs (volatility) that can be very stressful. So while cash may feel safe in the short term, there is a very real risk to your long-term wealth by limiting your investments to the assets that feel the safest.

The tradeoff between investing in volatile investments with higher expected returns (e.g., stock funds) and less-volatile investments with lower expected returns (e.g., bond funds and cash) is sometimes framed as the “eat well vs. sleep well” tradeoff. Each of us needs to determine how much of the higher-volatility investments--that are more likely to enable us to eat well in our retirement years--we can handle, while still being able to sleep well. Our goal should be to find a balance of stocks, bonds and cash that is appropriate for our risk tolerance. The reality is that some people simply can’t handle the volatility of stocks, and therefore must resign themselves to the lower expected returns of savings accounts and perhaps short-term bond funds, and accept that they must save more, work longer, or be willing to lower their living standards in retirement.

I highly recommend that you read “The truth about risk” on the Vanguard website, especially those of you who are just getting started learning about investing. To the right of the Vanguard article is an interactive chart that lets you see the historical performance of different blends of stocks, bonds and cash. Be sure to click on the different icons at the top-right of the chart that display the information in different formats. The first format (default) shows the volatility of the different asset mixes from year to year. The third format (line chart) shows the cumulative performance of the different asset mixes. Experiment with the ASSET MIX and TIME FRAME sliders under the chart to vary the blend of stocks, bonds and cash over different time periods. You can clearly see the higher-volatility, higher-return performance of stock-heavy portfolios over most long-term time frames, and the lower-return, lower-volatility performance of bond- and cash-heavy portfolios. Of course you’ll also see that over some time periods, bonds and cash outperformed stocks; for example, slide the left TIME FRAME slider to 1999 to see the period from 1999 through 2008. Unfortunately the chart doesn’t go through 2010, which would show the strong recovery in stocks from the March 2009 lows.

Although risk is commonly associated with volatility, especially shorter-term volatility, it’s also important to consider the risk of not building enough wealth to meet long-term goals like retirement. Of course that risk exists with stocks too, but if history is any guide, there is the very real risk that investing only in assets that feel safe in the short run will result in insufficient wealth to meet long-term goals like a comfortable retirement.

Learning about different types of risk and determining your own risk tolerance are critical steps in developing an investment plan that you will stick with in the long run. If you’re serious about building wealth for retirement and other long-term goals, you have to spend some time on this. To learn more, read the Vanguard article referenced above, see my other blog posts in the Risk topic (click the Risk link under the VIEW POSTS BY TOPIC section in the right column of the blog), and start reading some of the recommended books on investing.

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