The Risk “Free” Fallacy
Once again, “free” proves to be just another 4-letter word that starts with “F”.
The S&P500 has recovered a little more than 10% this year to the chagrin of many pundits calling for more doom and gloom. For the sensible investor that maintains a long-term focus, the static around the all-too-common market whiplash is largely ignored. For some, this market rebound is an unfortunate missed opportunity and the hunt for the right asset mix continues with a growing sense of desperation. Some unscrupulous finance “gurus” leverage this desperation to their advantage in service to their own wallets and egos. The cycle of market rally, followed by market selloff, followed by an increase in “no-risk” investment product sales, followed by market rally seems to be the economic equivalent of the Charlie Brown football trick for risk-adverse investors. While I cannot single-handedly break this cycle and tell Lucy that we’re done playing, I can attempt to elucidate the nature of risk as it pertains to your capital and why there is no such thing as “risk-free”.
Like our dog that futilely scurries under a bed to escape a thunderstorm, you cannot escape risk. You simply trade one for another. Selling a depressed stock investment in favor of a low-volatility investment does not make your portfolio more conservative from a risk perspective. It will decrease the portfolio volatility, yes, but low volatility does not equal low risk. In fact, you may substantially increase the odds of running out of money by taking this course of action. To get to the core of why this is, we need to consider the forces driving market demand for savings vehicles. Most of the capital we create will be utilized in the near term. Think of your paycheck, for example, how much of your paycheck will be consumed within the next twelve months versus the next ten years? If you’re like most Americans, probably a substantial portion. As such, there exists a natively high demand for liquid, low-volatility assets. Issuers of these assets, which are liabilities to them, do not need to offer large returns to attract capital flows because of the high demand. These instruments are great for satisfying our shorter-term needs; however, they are particularly poor at mitigating the creeping risk of inflation.
In a perfect world, we would all deal in cash instruments that completely mitigate inflation and would be salable enough to eliminate price volatility. This world is not our reality, and we must carefully balance our financial assets with our financial plan in consideration of our temperament. Inflation is a tricky thing to measure because it is specific to every individual. Many financial planners assume a 3% general rate of inflation but this may be too much or too little, depending on how you live your life. We must start somewhere so the historical average is a reasonable starting point. Using this generic assumption, we would need an average net return of 3% to just tread water. This would hardly be an optimal situation since all your compounded returns would be dedicated to staving off the effects of inflation. Ideally, you would want to leverage time like a sail to pick up additional returns that could stack above and beyond the rate of inflation, and these kinds of long-term returns are rarely found in low-volatility assets.
Yes, you could realize a successful long-term financial goal using low-volatility assets but you could also mow your grass with scissors. At some point, efficiency should matter and it’s better to just trust the mechanism. Some will never be able to trust the mechanism, constantly sticking their hands where they shouldn’t be only to wind up permanently harmed. If this is you, you should be saving a substantial portion of your income and/or maintain very conservative financial objectives while avoiding self-destructive investment behaviors. For most, however, it’s best to let market cycles work themselves out, trusting that our long-term capital is better-off invested with a benign disregard for volatility. Corporations must offer attractive above-average potential returns to investors to attract shareholders, which is essential for a company’s survival. This is an economic reality that has spanned multiple centuries, currencies, and governments. I don’t believe the next few decades will be much different. Also, there is no such thing as “risk-free” or “no-risk”, so don’t be fooled by those that suggest otherwise.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
Past performance is no guarantee of future results. Indexes cannot be invested into directly. Investing involves risk including loss of principal. No strategy assures success or protects against loss.
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