Katherine was a great saver. She always made sure that she put her maximum annual 401(k) contribution of $18,500 away during her entire 45-year career. She wanted to earn the most she could in the account, so she invested it all in equity funds. Given she didn’t really pay much attention to the account, the ups and downs of the market didn’t bother her. After all, she didn’t plan on touching the account until she’d stopped working. She retired with $5.3 million after earning an average 7% return.
Katherine found retirement very pleasant. She had enough money to do all the things she’d planned to do with her extra time—from entertainment to travel. She even managed to help her children with deposits on their first homes.
Katherine’s twin sister—Lucy—was also a great saver and put away exactly the same amounts as her sister all those years into her 401(k). But Lucy was always deathly afraid of losing money. She shunned the stock market, favoring instead a short-term bond fund that returned 1.0%, on average, over her 45-year career. She retired with $1 million, or with less than one fifth of her sister’s 401(k) balance.
Lucy’s retirement was a disappointment. She would have loved to have gone with Katherine on some of her international trips to Europe, Asia, and New Zealand, but she just couldn’t find the money. In fact, it was stressful just paying regular bills each month. She really was counting every penny. Her peace of mind in her working years about not losing money had now completely evaporated. She was confronted by a growing realization that retirement was going to be one long penny-pinching grind. This wasn’t what she expected after all those years of conscientious saving.
Risk Aversion is The Biggest Long-Term Risk
The story of Katherine and Lucy goes to the heart of a big mistake many future retirees make: being too risk averse. In her 401(k), Lucy effectively traded equity risk—and the temporary stress of periodic bear markets—for the even worse risk of permanent loss of purchasing power from inflation.
Lucy’s risk aversion is a widespread problem. For example, recent research by Bankrate.com found that only one third of millennials are investing in the stock market. And who can blame them? They grew up during the Great Recession of 2008-2009, when the S&P 500 halved in 14 months. That scarred the psyche of a lot of people, not just millennials. Many investors have, therefore, stayed on the sidelines, or been underinvested, in one of history’s greatest bull markets. Since bottoming in February 2009, the S&P 500 has almost quadrupled, and it’s up about 80% since the peak of the last bull market, excluding dividends.
For those that have been underinvested in stocks during this bull market, it’s been a painful lesson that to reap the long-term gains that equities offer, investors need to be invested. If you are not present in stocks, the long-term averages for stock gains do not apply!
Investors need to be prepared for the inevitable periodic sell-off in equities, be brave during the worst of the sell-off, and then be patient enough to enjoy the upside from stocks as they recover. It’s a fool’s errand to try to time when to get out of the market, and then back in. Some of the best brains in the world have been trying for years to achieve this holy grail of investing—without success. The prospect of amateur investors being successful in timing the market—outside of pure luck—is extremely remote. I’ve written on this topic here.
You’re Always Taking Some Kind of Risk
Now, I know it’s all very easy for me to say this. It still doesn’t stop it from being scary. But the sooner you recognize that no matter where you’re investing, you’re always assuming risk in some form, the better. It might just be that you’re not aware of those other risks. Let me explain.
Investing in the stock market is the easiest investing risk to identify. If you own stocks, and sell them in a bear market, you lose money. Although of course if you owned a diversified portfolio, and just did nothing until stocks recovered from their inevitable periodic nosedive, history shows sooner or later, you usually emerge wealthier. The biggest risk in equities is selling during a bear market. I devoted an entire article to the topic of portfolio diversification here.
You may instead be enamored with bonds, because they don’t decline in value like stocks do. And that has been the case since the Federal Reserve under former Chairman, Paul Volker, crushed inflation by hiking short-term interest rates to 20% in 1981. Since then bonds have been increasing in value as inflation and bond yields have fallen remorselessly lower. Until now, that is, because bonds carry a risk that’s been dormant for a long time: interest rate risk.
Both inflation and yields look like they could be on the rise once again. Will they reach the teens again? Highly unlikely. But can inflation cause bond yields to increase enough to seriously hurt bonds? Yes. Yields that increase from very low levels, such as where they are now in 2018, cause price declines in bonds that are much greater than when yields increase by the same increment from much higher yield levels. So medium to longer term bonds have very significant interest rate risk built into them right now. If interest rates surge unexpectedly higher, watch out.
You may be thinking: “Well, I can avoid risk by just keeping my money in the bank”. Keeping it in a regulated US bank, is free from risk of principal loss to the extent of $250,000 per depositor, per FDIC-insured bank, per ownership category. The prospect of losing your savings from the failure of a US bank remains exceedingly remote.
However, there’s another risk you take when leaving your money in the bank: inflation. Banks tend to lag increases in interest rates, and almost always offer interest that is below the level of inflation, which erodes the purchasing power of your money. Historical inflation has averaged around 3.1% since 1913, which means 25% of the purchasing power has disappeared every 9.4 years, on average. Even in today’s low inflation environment it’s a wealth destroyer. While inflation averaged just 1.69% between 2010 and 2017, 12-month CDs averaged a paltry 0.32%. If we assume a quarter of the CD interest was taxed, then 1.45% of the purchasing power of those 12-month CDs vanished every year. On that math, a quarter of your purchasing power would disappear every 20 years, despite low inflation. It’s even worse if you leave your cash under the mattress, where you’ll receive even less interest!
Others swear by insurance products, such as annuities. They can serve a legitimate purpose in a retirement plan, but know that many insurance products tend to have the same risk and return dynamics that interest paying bank accounts offer. Insurance-based retirement products usually offer gross returns that are higher than bank accounts, but are then subject to high embedded fees, due to their complexity and administrative requirements. Insurance products often offer investors the opportunity to offload the risk of principal loss in return for assuming the risk of lost purchasing power.
Local Real Estate Risk
Local real estate is a favorite investment of some. This combines various risks—geographical, operational, leverage, interest rate, and illiquidity—since it can take time to sell and costs 6% in broker fees. In a rising local real estate market, the leverage and “sweat equity” of doing everything yourself can pay off handsomely. But don’t kid yourself. In a declining real estate market, those layered risks can lead to foreclosure and even bankruptcy. Just because you can place your hands on that asset every day to assure yourself it’s still there, doesn’t make it less risky than, say, a professionally managed real estate investment trust.
Employment risk is another example of potential layered risks that look great when times are good, but spell disaster when times get tough. For example, your salary, incentive compensation, and even a large portion of your 401K may be dependent on the fortunes of your employer.
Take Risk Intelligently
Whether it’s equities, interest rates, inflation, credit, liquidity, or any number of others, anything you’re doing right now carries some kind of risk. The key to successfully navigating risk is not to emulate Lucy, who tried and failed to avoid it in all forms, but to understand the nature and amount of each kind of risk that accompanies each investment category. Then figure out how much of it you’re willing to assume and what it means for your overall portfolio. The result should be that no one source of risk imperils your retirement goals. Once you’ve done that, you’ve done what you need to do.