By Lewis J. Walker, CFP®
We take risks every day, just driving to the store or to work. Risk and reward are part of the reality of life, with the possible exception of those who insist that “everyone gets a trophy.”
In investing, you cannot avoid risk. Guaranteed bank deposits carry inflation risk. With inflation approaching 2% annually, money market funds and CDs offer negative returns adjusted for inflation and taxation. The risk is that “safe dollars” will buy less goods and services in the future. Yet, everyone should have an adequate storehouse of liquid and “safe money.” Growth of capital on a real return basis will have to come from other sources.
“Real” means a positive return net of taxes and exceeding inflation. If you want a net return of just 3% annually over and above an inflation rate of 2%, and you are at an average (not marginal) federal and state income tax bracket of 25%, you have to achieve a return of 6.67% consistently. That may seem feasible, but it’s not without risk. A 5% real return net of taxes demands a 9.33% gross return.
The risk you should take depends on a wide variety of factors and is worthy of in-depth analysis and discussion. Ultimately it comes down to determining what money has to do to meet your financial freedom goals. Fixed income bonds suffer from inflation, interest rate, and credit risk. The debtor may fail to pay. As interest rates rise, bond values decline. Bond management is tricky in today’s world of stressed debtors (see Puerto Rico) and low to negative interest rates.
Stocks are a proven way to build wealth over time (we stress “over time”). We know values fluctuate, sometimes painfully to the low side. Investing in real estate and other assets pose risks in that results may not meet expectations. Diversification can spread the risk, but the more you diversify, the more likely it is that some sector may under perform at any given time.
In pondering risk and reward, thinking devoid of emotion is useful. One nugget is the fact that market forecasts are consistently wrong, and should be regarded only as entertainment. A chart from Wall Street Publications from 1999 to 2005 showing Wall Street Strategists’ Average predictions plotted against the S&P 500 Index showed predictions to be up and down in a moderately jerky line as expected. But most of the time, actual market results were either significantly above or below the line. Market forecasts are of little use in improving the probability of returns. What is required is patience and consistent and patterned investment into vehicles like mutual funds, separately managed accounts, and retirement plans (dollar cost averaging).
You might heed the wisdom of John Templeton who advised “buying when there is blood in the streets.” Buying when fear is widespread takes trust and courage, and you are highly unlikely to hit the bottom of any cycle. Market timing does not work. Yours truly bought stock after 9/11. The market declined further after my purchase. But a year later I looked prescient. Peter Lynch opined, “Far more money has been lost by investors trying to anticipate corrections, than lost in the corrections themselves.”
When you invest in a stock or real estate or some other venture such as private equity, you are investing in a business. Long term the value of the investment will depend on the value of the business.However, emotion and headlines can impact investor perceptions, and the market price of the stock or other security may not reflect the true value (current or future potential) of the entity. Even those building value in their own business know that value creation takes commitment, hard work, and adaptability. Look at what happened to travel agencies when the airlines quit paying commissions. Even, now “creative destruction” is at work as old concepts fade and new ones appear, as in “the Internet of everything.”
Insurance in various forms can hedge some risks in life and preserve assets in the event of adversity or a personal black swan event. Proper levels of insurance and legal liability protection can at least create peace of mind while you go about building your empire. It’s about challenges, alternatives, resources, and expectations...and how money plays into that conversation.
As the British said during World War II, now a popular t-shirt slogan, keep calm and carry on!
Lewis Walker is a financial planning and investment strategist at Capital Insight Group; 770-441-2603. Securities and advisory services offered through The Strategic Financial Alliance, Inc. (SFA). Lewis Walker is a registered representative and investment adviser representative of SFA which is otherwise unaffiliated with Capital Insight Group.