The Risk of Too Little Risk

The world today seems like an exceptionally uncertain place. A policy misstep by the Federal Reserve or some other institution across the globe could send shockwaves through the financial markets. With all this uncertainty, the natural tendency is to hunker down, de-risk, and weather the storm. For someone with enough in the coffers, it seems like a no-brainer to avoid risk, but it may not be a wise decision.

Studies of human behavior show that we naturally prefer to take a sure thing over an uncertain future payout. Less obvious though, these studies show that we prefer the sure thing even if it is guaranteed to give us less money in the long-run. This behavior has a direct impact on how we approach planning for retirement. If you need $150,000 per year in retirement and you have the option to guarantee that $150,000 income stream, why do anything else?

There are plenty of insurance agents ready to sell a product to you promising this future income. In fact, you don’t even need to purchase an insurance product; you can achieve the same result in the bond market with a series of government bonds with varying maturities. For many investors that may have enough money today, this seems awfully tempting. Just buy an annuity or bond portfolio and go to the beach. Despite the appeal, these solutions sweep many issues under the rug.

First, inflation is likely to slowly eat into what that $150,000 can purchase year in and year out.  If prices rise at 2.5% per year (lower than the historical average but higher than some current forecasts), $150,000 will only purchase the equivalent of $71,500 in thirty years – less than half of what it purchases today. The incremental impact each year is small enough to go unnoticed as purchasing power slowly erodes.

Often, an investment strategy that attempts to reduce risks just shifts the risks around. Moving all your saving into CDs or fixed payment instruments like annuities or bonds may take the risk of a stock market crash off the table. But eliminating some investment risk exacerbates some other unforeseen risk like higher-than-expected inflation.

For savers, the risk of inflation is real. In the 1970s, inflation outpaced the return on CDs as inflation ultimately exceeded 10%. In the 2000s and more recently, the Federal Reserve kept a lid on interest rates in an effort to the stimulate economy. The result was inflation ran higher than what money could earn in the bank. In fact, over the last ten years $100 in CDs grew to $105. Unfortunately, $105 only buys about 90% of what the initial savings purchased ten years ago.

Rate of inflation since the 1970s.

Just as importantly, no one has perfect insight into the future. We can say we are happy living on $150,000 today, but unforeseen circumstances and changes in preferences may change that number. More travel and home renovations demand more from your savings just as much as unforeseen medical expenses. A financial plan should be flexible, and investments should be liquid enough to change course should life’s uncertainties require it.

Our lives and the world around us are defined by the unknown; eliminating the investment risk in your portfolio does little to reduce this. Engineers know that a system built with a single point of failure is not robust and is subject to periodic failure. Likewise, investment plans and strategies that often attempt to reduce worry and risks can often lead to unintended risks and consequences.

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