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Risk - Understanding the Tradoffs

Not only are we enjoying the hint of spring in the air, good news, we are now at about three years since the bottom of the Great Recession. Although we are highly likely to see continued volatility as the market sorts through earnings season and the ongoing European recession, it seems we are at least feeling a little better than we were in the spring of 2009.

Not surprisingly, in the past few years, we’ve have had many discussions about risk tolerance. If you were one of the three Mega Million jackpot winners (although our phone hasn’t rung yet with jubilant questions about how to invest the proceeds), you could afford to place your riches in T-bills and live off the paltry interest. But for the rest of us to enjoy a long and productive retirement, we will need some real growth in our portfolios to ward off an uncertain financial future that will almost certainly include a rising cost of living.

Few decisions are more important to that growth than the balance between capital preservation assets such as high-quality bonds, and long-term growth assets, such as diversified stock funds. You may have heard of this balance described as a mix of “safe” (bonds, bills and other stable value assets) versus “risky” (stocks/equities). Today, we’d like to dispel that misperception. The truth is, both are risky … in different ways.

  • Equities are risky in part because they are volatile. While they are expected to deliver long-term returns to help preserve your purchasing power, you never know quite what they’re going to do next in the near-term.
  • Bonds are risky because, while they help you preserve your original dollars, they are expected to erode those dollars’ purchasing power over time.

When planning for current or future cash flow from a portfolio, we want to manage both types of risk. Understanding the Tradeoffs between preserving capital and purchasing power can help us approach the task. To illustrate, consider over a century of performance data in the US financial markets.

The first graph, “Preservation of Purchasing Power,” shows that US equities have delivered a much higher nominal annualized return over inflation and Treasury bills.

However, as shown in the middle, “Preservation of Capital” graph, equity investors had to bear periods of high volatility. During the US equity market’s worst period (1929–1932), equities lost 69% of their value. By contrast, the worst period for US bills was in 1938, when bills lost 0.02% in nominal terms. If an investor cares most about preserving capital, bills would appear more stable than stocks.

But the picture is quite different after adjusting for inflation to arrive at real returns. The third, “Risk-Free or Risky?” graph shows the results. US equities still weathered a difficult period from 1929–1931, losing 60% in real value. More surprising is the 47% real loss of value for “risk-free” bills from 1933–1951. As shown in the solid box, the worst period for equities was much shorter than the worst period for US bills: four years vs. 19 years. And equities recovered much faster: four years vs. 48 years! Similar data can be found in other countries as well, including Canada, Great Britain and Australia.

In a world of speculative opinions and predictions as to what the next three years may hold, one thing seems likely. Investors who want to preserve their savings for a lifetime of spending are better served by tolerating short-term market swings in exchange for a high probability of increasing purchasing power over time.

A heart-felt thanks to all of you who have referred family and friends to us so far this year. We are honored by your continued trust and confidence in us. Please let us know if we can assist with any financial questions or concerns.