Avoiding risk can be the biggest risk of all
Playing it “safe,” mostly by investing in bonds, can lead to a lifestyle-draining predicament
When managing hundreds of nest eggs for families, we think about risk a lot. How one defines risk is as varied as the personality of individual investors and those of advisors. While one dictionary may define risk as the “effect of uncertainty on objectives,” we know that every investor defines, perceives, and tolerates risk differently.
It takes the ability to listen carefully and apply a strong dose of psychology to understand what risk means to each unique investor. It is easy to trot the old Chinese proverb of, “Pearls don’t lie on the seashore. If you want one, you must dive for it,” but it requires due diligence to discern why investors might be reluctant to take that dive.
Some investors define risk by how much their portfolio fluctuates. Others view risk in a more visceral sense – like the risk of outliving their money or the risk of not having enough assets to retire comfortably. Many investors frame risk as the pain they feel watching or experiencing volatility of the value of their financial assets.
Rarely does one express the same angst about the dramatic drop in the value of their home over the past few years since there is no ticker tape affixed to their mailbox.
Our role as advisers is to clearly help our clients understand and define different types of risk and how risk may impact their portfolio, lifestyle, and frame of mind. Some clients suggest that they are risk averse while simultaneously taking up skydiving on the weekends.
Most importantly, it is crucial to triangulate risk into your future hopes and dreams.
We believe a significant and often and overlooked risk is the loss of purchasing power; a standard of living inhibitor that comes through the accumulative impact of inflation. I consider inflation as an unseen force, like gravity -- and, like gravity, it can bring you back to earth quickly.
Understanding inflation over time, and its impact, is a fundamental pillar of successful investing -- as important as the power of compound interest. Yet, ignoring inflation is only normal, given the disinflationary and low-interest-rate environment in which we currently live.
The perception that prior events might extrapolate into the future is a significant risk. Given what we know about the recent volatility in the equity markets, investors have been looking to invest their free cash in assets considered less risky.
The cost of ‘less risky’
There’s a catch. And it can be a costly one, if one dismisses inflation completely. Ignoring potential inflation can cause a host of concerns – like, “I don’t have enough money to retire on,” or “I can’t send my kids to college because I can’t afford it,” or “I can’t pay the beneficiaries out of my corporate, or government, pension plan.”
Investors seeking to calm those fears with more conservative investments could be ignoring the reality that their idealized money goal may not be attainable. In their rush to dampen volatility of their portfolios, they might be ignoring the possibility that over the next five years, or even a decade or more, their money simply won't be able to do what they need it to do.
The price of investing in assets considered “less risky” has become more expensive when one recalls that a drop in yield means a higher price in the bond world.
It is my opinion that fears in the current markets and a potential dear pricing of conservative assets has set the stage so that investors are unlikely to reach their goals investing strictly in perceived “riskless” assets.
If one assumes even a modest rate of inflation of 3 percent over the next decade, sovereign and corporate debt could lose purchasing power in the future – perhaps significantly. In my opinion, it doesn’t take much to realize that avoiding risk might be the greatest risk of all.
As Canadian businessman Brian Tracy put it, “the more you seek security, the less of it you have.”
This is where the growing field of behavioral finance comes into play for an adviser who is covering all the bases. It is crucial to recognize that investors are not being foolish by acting risk-averse. In reality, investors are acting very human, and this is how we are wired.
I also believe it is very important to educate the public and our clients about the long-term effects of inflation and how it can erode investments. We urge our clients to think about it in terms they understand, by comparing what they pay for goods and services now compared to just a few years ago. Being “safe,” mostly by investing in bonds, can lead to a lifestyle-draining predicament of attempting to purchase tomorrow’s groceries with yesterday’s buying power.
Tom Sedoric, managing director-investments of the Sedoric Group of Wells Fargo Advisors in Portsmouth, can be reached at 603-430-8000.