When most people think about “risk,” in the context of personal finance, they are talking about the possibility that an investment could lose money. If they invest in mutual funds or variable annuities, they could thinking of market risk writ large: That an entire asset class could lose money. And so people who are very risk averse tend to shy away from assets they view as ‘risky.’ Like stocks and mutual funds.
Well, the fact is that stocks and mutual funds are risky. But pretty much everything is risky – and the way to minimize risk isn’t to try to avoid it altogether, but to try to mitigate it by taking on different kinds of assets that tend to cancel out each other’s wild swings, while still growing over the long run.
Let’s take a look at one woman who tried to avoid risk – by keeping her life’s savings in a plastic bag in her home. The woman lives in China – a powerful economy, but an economy still plagued by corruption and a lack of transparency. She thought she could avoid the risk of Chinese banks and other forms of savings and investment by keeping cash in her home.
Unfortunately for her, even though the capital markets couldn’t do much damage, the termites got to her savings and did what the stock market could not: Eat through a substantial portion of her life’s savings.
If you’re one of those people who keep a substantial amount of your money in your home, termites aren’t the only risk. People in Colorado Springs are well aware of the danger of wildfires – over 300 homes in the area have been destroyed over the past week – along with any cash left in them, unless they had some seriously fire-proof safes.
Thieves are another risk – and thieves aren’t necessarily strangers. They could be people in your own family. Your risk is substantially elevated if someone in your family develops a drug or gambling addiction. If there is any hint of these problems in your family, in addition to seeking professional counseling, I encourage you to seriously rethink any strategy that relies on keeping cash, jewels or other valuables in your home.
Inflation is another doozy – and one that is particularly difficult to guard against in a low-interest rate environment such as the one we have now. With 10-year Treasury bonds yielding less than 2 percent, even a slight uptick in inflation can mean a net inflation-adjusted loss to any portfolio that emphasizes safety of principal to the detriment of all other considerations. Inflation eats away at your spending power over time, and ultimately, your lifestyle. And you cannot deduct losses from inflation. Indeed, under capital gains rules, you get taxed even on gains that have been devoured by inflation. Why? Buy an asset for a dollar, and sell it after 30 years for two dollars, and you still get taxed the same capital gains rate you would had you just held the asset for a year and a day. The tax code doesn’t care that that dollar is now worth just 25 cents, compared to what a dollar bought when you acquired the asset. Inflation is an insidious cancer on investment returns and slowly kills owners of assets just as surely as the termites ate that poor woman’s life savings.
There are some things you can do to mitigate inflation risk, though:
- Buy gold and precious metals
- Buy real estate and/or land
- Buy commodities
- Buy TIPS, or inflation-protected securities. These are treasury bonds that pay a lower yield than garden-variety bonds of the same maturity, but pay out a bit extra if inflation heats up.
- Buy assets that you have a reasonable expectation will outpace inflation. At current levels, I’m not a big fan of long-term low-yield bonds for this reason: They just aren’t yielding enough to cover inflation risk.
- Buy an inflation-protection rider in an annuity. These can be pretty pricey, though. The annuity company isn’t going to take on inflation risk for you without being pretty well compensated for it. Though this is true no matter what asset you’re buying – all markets will adjust for inflation risk, all things being equal.
Even muni bonds are no panacea. The City of Detroit defaulted just this month. Heartland Funds was forced to write down the value of one of its high-yield municipal bond funds by over 50 percent in one night, because they were simply inaccurately priced because the securities in the fund were so thinly traded.
The bottom line – It’s just as the excellent veteran personal finance writer Chuck Jaffe wrote in this column: There is no such thing as a ‘risk-free’ investment.
The smart thing to do is develop a budget for risk. Allocate your risks among several different types – so a negative event in one asset class doesn’t clobber your whole portfolio. Need help developing a risk budget? That’s where we come in. Give us a call and we’ll walk you through it, based on your timeline, your tolerance for uncertainty and your individual financial objectives.