Why take investment risk?


CarolinaFireJournal - Bart Valley
Bart Valley
10/18/2009 -

Last year’s stock market decline created significant stress for investors. Unfortunately, in times like last year, we often see investors panicking and moving out of risky assets such as stocks into safer holdings like savings accounts or Treasury bills. But the truth is these safer investments have never produced the kinds of real returns that most investors need. Safe investments like savings accounts or Treasury bills might eliminate investment risk, but they introduce another problem: purchasing power risk.

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The most dangerous enemy for most investors is inflation: goods and services grow more expensive over time. Through the years, it costs us more to buy our gas, to go out to the movies, to pay our electric bill. If your savings and investments are not growing at least as much as this inflation, you are actually becoming less wealthy over time in real terms -- you are losing your purchasing power.

Consider the example of someone who kept their cash savings in a safe at home over a 10 year period. If the goods and services that individual purchases get 20 percent more expensive on average over the 10 years, then that person effectively becomes 20 percent less wealthy. He may not have lost any real money, but he has lost some of that money’s power to buy things.

Savings accounts and Treasury bills may have little risk of instability, but they have significant purchasing power risk. If you consider real return (the return on an investment net of inflation), Treasury bills have only returned on percent per year historically. If you consider the taxes you would have paid on your interest income, returns would be close to zero percent or even negative.

Stocks, on the other hand, have averaged six percent per year in real return. Risk, when viewed in this manner, can be significant for seemingly safe investments. In fact, the worst ever 10-year period for real returns on Treasury bills (-42.1 percent for the period ending February 1951) was worse than the worst 10-year period for stocks (-39.6 percent for the period ending February 2009). So in terms of real return, which is what we should really care about, “safe” investments can also be quite risky.

Years like 2008 can be very painful for investors, but it is important to find a proper balance when investing for retirement. You need significant real returns to finance your retirement and maintain your standard of living, but you can’t do that without some risk. If you do not invest any of your long-term savings in riskier assets, you leave yourself exposed to the risk that your savings will not buy as much as you thought they would when you are ready to retire.

S. Bart Valley, CFA, graduated from Cornell University in 1994 with a B.A. in Economics. He serves as Chief Investment Officer of Abacus Planning Group, Inc. where he advises clients on asset allocation decisions, investment policy formulation, portfolio design, security selection and investment implementation. Bart received his Chartered Financial Analyst (CFA) designation in 2003. The CFA designation is recognized as the definitive worldwide standard for measuring competence and integrity in the fields of portfolio management and investment analysis.
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