Most people dislike losing far more than they enjoy winning. Psychologists call this “loss aversion” and suggest that losses are twice as powerful as gains on an investor’s psyche.
In this month’s cover article, investment pro Howard Marks describes dealing with risk as “the essential element in investing,” and notes that “most level-headed people want to avoid or minimize” risk. The greater an investor’s desire to avoid loss, the greater will be his or her desire to avoid risk.
Minimizing risk, of course, is the driver behind many money management fundamentals. For example, the idea that everyone should maintain a reserve of money in an ultra-safe savings account is to minimize the risk of a financial emergency such as a job loss or unexpected major expense. When it comes to investing, diversifying one's holdings rather than putting all of our eggs in one basket helps minimize the risk of being overly concentrated. This type of advice is appropriate and helpful.
However, sometimes the riskiest thing you can do financially is to play it too safe. Here are a couple of examples.
- Letting compound interest slip away.
Young people often are stereotyped as inherently bold risk-takers. But when it comes to today’s young people, that profile is completely wrong. A 2014 UBS study of the investment attitudes and practices of people across generations found Millennials (people age 21-36) sound and act more like senior citizens on a fixed income. Marked by the Great Recession’s impact on their parents’ portfolios and their own job prospects, they are highly cautious in their approach to investing.
The UBS research found Millennials almost as likely as people age 68 and older to describe their risk tolerance as “conservative.” In fact, the average Millennial has over half of his or her investment portfolio in cash! The study noted, “This is directly counter to traditional long-term investment allocation advice.”
The similarity between today’s Millennials and much older investors was not lost on UBS: “This is remarkable given the impact the Great Depression had on the WWII generation and speaks to the potential permanent scarring that 2008 had on the Millennial investor.”
Today’s young investors are playing it far too safe. They have an abundance of time ahead — an investor’s most precious resource. And yet, by fearfully staying out of the market, those in the best position to take advantage of compound interest are taking a pass, making the task of saving for their later years much more difficult than it should be.
- Failing to recognize the impact of future inflation.
I recently spoke with a 65-year-old new retiree who has all of her retirement savings in cash. She said she could live on Social Security and the $450 she was taking out of her retirement savings each month. When I asked how long her savings would last if she kept taking out $450 each month, she knew the answer immediately — a little more than 25 years.
She had run the numbers and thought she was in good shape. But she isn’t. Over time, because of the corrosive power of inflation, $450 will buy far less than it does today. Which means her standard of living will steadily decline as the years pass.
This investor doesn’t want to take any risk. Yet, by playing it too safe, she isn’t just risking the possibility of financial trouble down the road; she’s all but guaranteeing it.
To better prepare for the future, investors nearly always need to accept some degree of risk. In this case, even the extremely conservative step of buying an annuity with an inflation rider involves some small risks. An annuity would likely provide her with a higher monthly income while also locking in some inflation protection, but even so her cost of living could still rise faster than inflation. Or, she could die soon, leaving her heirs with less.
Alternatively, SMI might suggest keeping three to five years’ worth of expenses in a savings account, then investing the balance (or part of it) using a strategy designed for risk-averse investors, such as Dynamic Asset Allocation.
Either way, the risks of action must be weighed against the risks of inaction.
Investment risk certainly should be managed, and to whatever degree possible, minimized. No one gets bonus points for taking extra risks. However, sometimes the riskiest thing you can do is to play it too safe.