The Risk of Being Too Conservative

The Risk of Not Investing or Being Too Conservative

“The one thing I can guarantee will not work well as an investment is cash.”

– Warren Buffett

Most investors understand that investing is necessary to maintain purchasing power and stay ahead of inflation. They also understand risk versus reward. When talking to retirees about having enough money to live out their days, the major concerns are loss of principal and investment volatility. Whether you are 25 or 85, everybody wants to make money and nobody wants to lose money. The real question is how much volatility each individual can handle, or what amount of drawdown is tolerable during difficult market cycles.

When investors are risk adverse, they often think cash is a safe investment. It doesn’t move so nothing is lost, right? On the contrary, cash is a guaranteed loser to inflation. Inflation is an increase in the volume of money and credit relative to available goods resulting in a substantial and continuing rise in the general price level. In other words, inflation can negatively affect your purchasing power.

Conservative savers who put their cash in certificates of deposit are very often losing out to inflation. If inflation ranges from 2 – 3%, but a CD is yielding less, then inflation is eroding the purchasing power of each dollar by approximately 1 – 2% per year.

I bring this up not because CDs are necessarily bad investments, but because it illustrates the nature of risk. Investors often think of risk far too narrowly — just in terms of volatility or loss of capital. In fact, risk is all-encompassing, and like energy, can be neither created nor destroyed. When you buy a CD, you have massively reduced your risk of capital loss. (It would require the bank to go out of business and the government to refuse or be unable to pay off depositors.) However, you have massively increased your risk of losing purchasing power due to inflation. Your risk hasn’t gone away, it has just changed form. Remember, risk cannot be created or destroyed. You can pick your poison, but you can’t opt out.

The former point is almost always much harder for investors to grasp. Your risk is the sum total of all of your exposures — and the sum total of all of the things you don’t own. If you own a house, you have real estate risk and US dollar risk if the asset is held in the US. Less obvious is the fact that you now have the opportunity risk of not holding everything other than a house! For example, owning your house precluded you from buying emerging market stocks, or Swiss Francs, or energy futures with the same money. Depending on the relative performance of that investment opportunity set, your decision to buy a house could end up costing you a lot—relative to what else you might have purchased.

Psychologists will tell you that humans significantly overvalue the tangible relative to the potential. As the saying goes, a bird in the hand is worth two in the bush. Losing money that has already been earned hurts much worse than deciding not to put money into a stock that later doubles in value. Losing money always feels worse than losing opportunity — and it is for this very reason that investors’ biggest losses are usually the ones they never see. Opportunity loss typically swamps capital loss over an investor’s lifetime. Like a black hole, opportunity cost is very real even if you cannot see it. Investing is never without risk. You are just navigating a set of tradeoffs, with different risks inherent in each. Depending on the assets you own, your specific risks will be different from another investor, but your risk will remain just the same.

The moral of the story is that you must take on some risk, just to keep your dollar a dollar.

Beating inflation should be the minimum benchmark in anyone’s savings plan. However, people are either unaware of inflation or choose to ignore it. As you can see, the effects on the purchasing power of your money can be devastating. So with cash dollars currently losing value by 2% – 3% per year, why would people put their money in an account where it is knowingly losing money every day?

The simple answer is security.

  • Security in the knowledge that the numerical amount of money won’t fall (even though purchasing power will)
  • Security in the knowledge that it can be an emergency fund at any time without having to give notice or sell assets.
  • Security in the knowledge that the value of the emergency fund won’t fluctuate with market trends or values.

Understanding that it is important to stay ahead of inflation, let’s review a simple calculation for figuring what it takes to double your money. It’s known in our industry as The Rule of 72. By dividing 72 into the rate of return, an investor can roughly determine how many years it will take to double the original amount invested, or earn a 100% return. For example, a 9% compounded annual rate of return will take 8 years to double the original principal invested. An 8% return takes 9 years, a 7% return takes 10 ¼ years, and a 3% return takes 24 years. In actuality, the 3% return really just keeps up with inflation. So in 24 years, a ZERO% return could result in your purchasing power being cut in half!

Beyond your household operating capital and your emergency fund, now how content are you with your cash in a savings account or CD?

For more information, please contact Scott Brooks at 949.545.6500.

Gold Coast Wealth Advisors