Many investors prefer to invest in very safe but low-returning investments like CDs, bonds, savings accounts, and insurance-based products such as whole-life insurance. These investments appear to be safe because the returns aren’t volatile like those of higher-returning investments such as stocks and real estate. In reality, though, they can be even more dangerous. Perhaps an investor’s greatest opponent is inflation. Even inflation of just 2 to 3 percent a year presents a formidable threshold to investments that yield only 1 to 2 percent a year. Nobody likes to see their investments drop dramatically in value, but the alternative is to be forced to spend less than you would have otherwise in retirement or face running out of money if you live long enough. Investors who prefer low-volatility investments have likely never run the numbers to really understand what their investment preference means.
For example, an investor who wants a portfolio to provide 50 percent of pre-retirement income but who achieves an investment return that only matches inflation (0 percent real) and wants a 25-year career will require a savings rate of 50 percent of gross income for each of those 25 years. Very few doctors are willing to save that much of their income. Alternatively, the investor can work for 40 years while saving 31 percent of income. A more risk-tolerant investor who achieves a return that beats inflation by 5 percent, on the other hand, would need to save only 25 percent of income for 25 years, or 10 percent of income for 40 years, to have the same retirement spending level. The bottom line is that almost all investors need to take on a significant amount of risk in order to meet their financial goals.
A REASONABLE RISK?
Phil DeMuth, PhD, managing director at Conservative Wealth Management, LLC, has said, “Even if risk tolerance existed and could be measured accurately, why would it be an important factor when considering how to invest? You should invest in the way that has the greatest prospect to fulfill your investment goals. That might mean taking more or less risk than you would prefer. If you are a sensitive soul who can brook no paper losses, the solution is to get a grip, not to invest ‘safely’ if that locks in running out of money when you are old.”
There are many investing “products” (most of them insurance-based) that are marketed as reducing the risk in investing. However, these same products are also likely to reduce the return so much that a typical investor cannot afford to have any significant chunk of a portfolio in them. Financial theorist William Bernstein, MD, said, “There are no free volatility-reducing lunches that will inexpensively reduce your portfolio risk, and there is no risk fairy to insure the risky parts of your portfolio on the cheap. Yes, there are people who—and vehicles that—will do this for you, but they will cost you a pretty penny.”