I am more concerned about the return of my money than the return on my money
– Will Rogers
Loss of investment capital is a risk all investors worry about. In fact, studies have shown that investors hate losing money twice as much as they enjoy making it. This drives them to “safe harbors” such as CDs and money market accounts at the smallest sign of uncertainty in the economy. Yet if they were to consider the opportunity cost of “playing it safe” they may allocate their capital differently. What may be helpful when evaluating various asset allocation options is to consider the risk of failure to reach one’s financial goals. Your ultimate goal when investing is not to beat the market or some arbitrary index, but to reach your financial goals with the least amount of risk to your investment capital.
Unfortunately investors do not always start with clear financial goals. Your goals, whether financial or otherwise, must be specific and time-bound. In other words, “to get rich” is not a goal but a pipe dream, whereas “to have a net worth of $ 1 million in 20 years” is a real goal. Another component of a
good goal is that it must be realistic. Realistic financial goals stem from an honest assessment of your present situation and a clear understanding of historical risk/return attributes of various asset classes (stocks, bonds etc.). A common measure of risk in the financial world is the volatility of the asset characterized by its standard deviation.
The following chart shows historic risk and return of some basic asset classes for the 75-year period from 1926 to 2001. **
|Asset Class ||Annual Return ||Volatility|
|Large Company Stock ||10.2 ||20.3|
|Small Company Stock ||12.2 ||34.6 |
|Long Term Corp Bond ||5.4 ||8.4|
|Long Term Gov Bond ||4.8 ||8.8|
|Intermediate Term Gov Bond   ||5.1 ||5.7|
|US Treasury Bills ||3.7 ||3.3|
It is evident from the above chart that over long periods of time, higher returns are accompanied by higher volatility. The asset class with the highest return, small company stock, was 10 times more volatile than the US Treasury Bill. However, what is not so obvious is the degree to which a few percentage points in annual returns can make in the long run. For the 75-year period shown, $1000 invested in the safe US Treasury Bills grew to $12,190. In the same period, $1000 invested in large company stock grew to $810,540! The difference in return from large company stocks and the return from Treasury bills is called the Equity Risk Premium. This is the premium an investor receives for taking on the additional volatility. Historically, the equity risk premium has been around 6.5%. Clearly, for someone with a very long investment time horizon, the equity risk premium can be the difference between scraping by in your retirement versus relaxing in a beachfront house.
The Unseen Risk
One risk that investors often overlook when fleeing to so called “safe investments” is inflation
. For the long-term investor, inflation is a beast that must be tamed. Inflation slowly erodes the value of your nest egg day by day, week by week, year by year. It is the classic “boiling frog syndrome.” The premise is that if a frog is placed in boiling water, it will jump out, but if it is placed in cold water that is slowly heated, it will not perceive the danger and will be cooked to death. The insidious nature of inflation is illustrated by the high interest rate period of 1979 to 1981. During this period, an investor in the top tax bracket purchasing Treasury bills yielding over 12% actually lost his principal 3% per year due to rampant inflation which averaged 11.5%. This example is worth quoting when you hear someone wishing for the sky-high rates of money market accounts in the early 80’s. For the long-term investor, inflation is a higher risk than volatility.
Part 2 - What is a Low Risk Investment?
Part 3 – Is Index Investing The Answer?
Part 4 – A Free Tool for Identifying Low Risk, High Return Investments