We live in a world where risk is avoided more often than before. Maybe this is because of our illogical aversion to loss or our lawsuit culture, but the evidence is visible everywhere. Our automobiles come with dual, side, and rear airbags. Children are now escorted by a parent the few steps to their bus stop. Mattresses come with warning labels that read, “Do not attempt to swallow.” We go to such lengths to avoid risk that perhaps we should ask ourselves, “What is all this risk avoidance costing me?”
For an investor, risk can’t be entirely avoided, but it can be reduced. We all know that bonds are less risky than stocks, and that CDs and cash are even less risky than bonds. What if two investors save the same amount each year of their working lives, but take on different amounts of risk? Let’s say Mr. Low Risk invests $10,000 per year for 35 years in only fixed income assets that average a return of 5% over that period. In 35 years, his portfolio would grow to $320,983 in today’s dollars (assuming a 3% inflation rate* per year). At the same time, Ms. Moderate Risk invests the same dollar amount per year in a half stock, half fixed income portfolio. We’ll assume that stocks average 10% per year*, fixed income assets still earn 5%, and inflation is again 3%. The result is $548,185 in today’s dollars, 71% more than Mr. Low Risk. That’s a huge price to pay for the comfort of not experiencing the volatility of stocks!
If you are past the accumulation phase of life and are now drawing income from your investment portfolio, there is still a cost to avoiding risk. Your parents may have taught you to not take risks with investments in retirement, but their retirement was likely a lot shorter than yours. The real risk you should be trying to avoid is not the volatility of the stock market, but the risk of outliving your assets. Most retirees need to take on some volatility to avoid the greater risk.
*Assumptions based on data from DFA Matrix Book 2012. 1926-2012