Recently, I met with a husband and wife contemplating retirement. However, before making this change they wanted to discuss a recent article I had written. The article in question discussed the fact that people need to work longer and save more to offset increasing life spans and health care costs.
As we visited, John and Sharon told me they were entering retirement and didn’t want any risk.
It is a statement we have heard many times before and one that is at the top of most people’s minds.
However, I responded by saying “Which risks are you talking about?”
They looked at me like I was mentally slow and then John said “We don’t want to lose any money.”
As it turned out, John and Sharon had their entire portfolio in technology stocks in 2000 and the pain of money lost was still quite real. It was obvious their concern was default risk.
Understanding this, I asked for their thoughts on inflation and taxation risks.
John was silent but Sharon replied “What do you mean?”
It is easy to focus all of our attention on default risk. As we enter the latter stages of life, we want things simple and recognize we have less time to make up for mistakes.
Despite this desire, there is another risk investors must address too – whether looking at retirement or another goal. This risk is being too conservative.
I know that sounds crazy, especially given all that investors have faced recently.
It’s easy to see why people prefer the conservative route. However, there is a cost in making this decision.
In analyzing nearly 200 years of data, the broad stock market has produced returns of about 7 percent per year – after inflation. Pretty nice returns.
The fixed income market, in comparison, has produced returns of about 3.5 percent per year after inflation.
However, there have been long stretches where the fixed income market has actually produced negative returns after adjusting for inflation. Between 1966 and 1981, the fixed income market actually lost 4.2 percent per year after adjusting for inflation.
Further compounding matters, fixed income investors cannot find anything close to an inflation adjusted return of 3.5 percent in today’s market.
Additionally, consider that today a 10-year US Treasury will pay interest of about 1.5 percent per year. And then you get to pay taxes and incur inflation.
When I explained this to John and Sharon, I could tell they were doing the math in their heads. They realized a 1.5 percent return would produce a negative 1.2 percent return after factoring in inflation of only 2.7 percent.
If inflation is running higher, it is just that much worse. We estimate our clients are experiencing about 4.5 percent inflation – which is negative 3.1 percent net. Over the next 25 years, just 3.1 percent net inflation will erode your purchasing power by 55 percent.
They both realized the issue. Choosing the “no-risk” investment actually guaranteed their portfolio would lose purchasing power. Doing the apparently safe thing guarantees your principal is still there – it just won’t be able to buy you much.
As we continued our discussion, I offered up a few suggestions. First, don’t chase after fads like Internet stocks. Keep your stock portfolio diversified with things you understand.
Secondly, understand when it’s appropriate to own stocks or fixed income assets.
The stock market is wildly volatile over short periods of time. Over the past 50 plus years, the stock market has produced returns of more than 55 percent in any one year – and losses of more than 35 percent in any one year. That is almost 100 points of variability in any given year.
Over longer periods of time, however, the volatility of the stock market smoothes out and delivers much better returns. In our opinion, stock market investors should have at least a 10-year time frame.
Fixed income still has a place in a portfolio. Despite the lower after tax and inflation adjusted returns, fixed income assets can satisfy investor needs for five years or less.
Dave Sather is a Victoria Certified Financial Planner and owner of Sather Financial Group. His column, Money Matters, publishes every other Wednesday.
Originally published Tuesday, December 28, 2010
Victoria Advocate