The recovery from the 2008 credit crisis has been slow and drawn out. The Dow’s lowest point was almost 6 years ago and the Federal Reserve is still trying to stimulate the economy back to full speed. For many Americans, putting money in the stock market seems like a gamble. This is especially true for those 35 and younger. They don’t have much personal experience with investing outside of the volatility of the last 10 years. The last decade leads many to seek “safety” for their money.
How Safe?
“Safe” is relative. There is no standard of safe. When someone says their money is safe, it is always safer than some other investment, but it is also riskier than another investment. “Safety” is a spectrum. You can always be more safe, and you can always be less safe. There are moderate norms for safety that we apply to ourselves every day. We want safety, but there is a point at which we feel “safe enough.” Don’t believe me? Why do you only have a seat belt in your car? Why haven’t you installed a 3-point harness? Or better yet, why don’t you wear a fire-retardant suit and helmet when driving? The reason is because we are selective about what we protect ourselves from. The same is true of our money. We pay attention to the risks the media points out, but ignore others.
Safe From What?
When talking about safety for our money, we need to define what it is that we want to protect our money from. Stocks are widely thought of as the least safe investment. People don’t want to “gamble” in the stock market, because you could “lose it all.” This is true. You could, especially if you’re invested very narrowly (only in specific companies or types of companies). You can mitigate this risk by owning a broad range of stocks. If the company in which you are investing goes broke, your investment does too. I don’t need to convince you of the risk of the stock market.
Interest Rate Risk
Just as stocks are widely thought of as risky, bonds are widely thought of as safe. But again, we need to ask ourselves what they are safe from, because nothing is safe from everything. Bonds are stable, which is not to be confused with safe. Bonds grow and give returns at much more predictable levels than stocks. However, bonds, unlike stocks, are subject to interest rate risk. As interest rates increase, bond prices go down. They are like a see-saw. This is just a fact of how they are structured. The longer the bond term (30 year bond as opposed to a 30 day bond), the bigger the swing in price when interest rates go up. The reason for this is simple: If you buy a 30 year bond at 5% and interest rates climb to 6%, no one is going to want to buy your bond from you, because they can get a new one at a higher interest rate. If there’s no demand, the value drops.
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Interest rate risk is a big problem right now because interest rates are at historically low levels. When (not if) they go up, bond prices will (not might) go down. If you have bonds in your retirement account, make sure they are short or intermediate term, rather than long term.
Inflation Risk
Cash is king, so they say. One of the things it is king of is inflation risk. People who lived through the 30s insisted on keeping cash under their mattress for fear that banks wouldn’t cough up their money. Inflation slowly raises the prices of goods and services over time, which means that $1 never goes as far as it used to. Historically, inflation is around 3.3% per year, causing a gallon of milk to be 3.3% more expensive each year, on average. This is a problem for cash, and any investment that doesn’t return more than 3.3% per year. If you hide $1000 in a safe today and forget about it for 22 years, it will only be worth about $500. It’ll still be $1000, but it will only buy what $500 would have been able to buy 22 years earlier. So in purchasing power, it has lost about half its value. That’s a 50% loss on your investment in cash.
Legislative Risk
President Obama recently announced that he would like to eliminate the tax free withdrawals from 529 college savings plans (which essentially makes them pointless). He received near universal backlash and quickly withdrew the idea from the table, but it demonstrates another risk nonetheless. Congress is under no obligation to follow rules passed by their predecessors. If a new Congress doesn’t like a law, they can repeal it. If they want to tax something, they can, even if prior legislation says it would be tax free. For example, as of now, you can withdrawal money from a Roth IRA account completely tax free. However, this doesn’t necessarily mean that Roth distributions will always be tax free. Just because Congress can make changes, doesn’t mean they will, though. Many believe it would be political suicide for Congress to do such a thing, but its possible that 15 years from now, people may think differently. A lot can happen in 15 years (Remember the pre-9/11 world?). If its possible, then it is a risk. Legislative risk isn’t going to affect your returns, but it could affect your taxes, which is essentially the same thing, since the more Uncle Sam keeps, the less you get to live on.
Get Used to It
Risk is a fact of life. You are always one heartbeat, one freak accident, or one big mistake away from injury or death. We are used to this fact because it is everyday life. Rarely do you think about the risks you are subjected to. The same can be said for finances. Don’t let risk keep you up at night. Obviously, we should take steps to reduce our risk, such as diversifying our investments and buying insurance, but don’t get carried away. There is no investment that is safe from all risk. Don’t miss the growth potential of the financial markets because you are scared of risk, because the fact of the matter is that if you are not exposed to the risks of the market, then you’re exposed to some other risk. Manage risk by having money in all different types of investments. While everything can lose value, the chances that everything will all at the same time is negligible. By being exposed to every risk you are also kept safe from every risk.
-N&$
Numbers And Sense 