People sometimes tell me that they don’t want to take any risks with their investments.
I have to tell them that all investments have risks. Even those supposedly “safe” investments like putting money into a bank account or a term deposit, or putting it under their mattress(!).
In fact, I sometimes have to point out that by investing so “safely” they’re actually ignoring an equally important risk.
But for many people, the bigger risk doesn’t relate to day-to-day fluctuations. The bigger risk relates to being invested too conservatively, and ending up in a worse position than they could have been.
Consider a 65 year old who has $500,000 to see them through their retirement. Let’s assume they want to spend $25,000 (adjusting for inflation) from their investments every year throughout their retirement. Let’s say they invest in term deposits. They might get, say, a 4% return. But after we factor in tax on that income, and adjust the return for inflation (because every year that $500,000 is getting less valuable in terms of what it can buy, at approximately the rate of inflation), the after-tax, inflation-adjusted return might be more like 1.5%.
This is what their investment portfolio will look like (all figures are adjusted for inflation):
They’ll run out of money before they turn 89.
If they can invest slightly more aggressively and bump up the return on their investments by just 1% and keep everything else constant, their portfolio will look like this:
The chart looks pretty similar. But they don’t run out of money until after their 93rd birthday. That’s four extra years.
Or consider someone who is 40 years old with an investment portfolio of $100,000. They diligently save $15,000 (which they increase in line with inflation) every year until they reach the age of 65. If they only invest in term deposits because they don’t want to take on any “risk” and generate a constant, after-tax, inflation-adjusted return of 1.5%, they’ll end up with just under $600,000 when they turn 65:
Alternatively, they could invest a portion of their assets such as shares, which are more volatile on a day-to-day basis but tend to generate better returns over the long-run. Let’s say the return they generate is 4%. In this scenario, they end up with nearly $900,000 at the age of 65.
They retire with nearly 50% more than they otherwise would have.
In this latter scenario, they would have experienced ups and downs. The chart above isn’t representative – it wouldn’t be a smooth line. It would be a set of jagged ups and downs. But the general trajectory and long-term outcome is more likely to resemble the latter scenario.
So I ask you: What is the riskier strategy?
When investing in financial assets, it’s important to realise that all investments have risk. Even the “safest” investments involve risk. You might think you know what return you’re getting with a term deposit or a guaranteed income investment. But even here, you don’t know what your investment will actually be in terms of buying power over the long-run because inflation comes into the equation.
In contrast to the risk of day-to-day volatility, the other big risk that you need to balance is the risk of investing too conservatively – and ending up in a worse position than you would have been.
It’s important to find the right balance of these major risks for you. But it helps to start with the knowledge that you’re always exposed to risks, and appreciating the value of making a conscious choice of how to balance these risks – in light of your own circumstances, needs, objectives, values, and priorities.