In my last post, I believe I succeeded in putting any unwitting readers to sleep by providing the academic/economic definitions of investment risk. However, in real life, there are two risks that we see on a regular basis that I think are much more important to address.
The first, I alluded to in my prior post. It is the "nightly news" risk. Here, at Leonard Wealth Management, our clients' equity portfolios are extremely well diversified with large amounts of exposure to U.S. large value, small cap, small value, International large value, small cap, small value, and emerging markets. Many of these groups have done tremendously well, especially compared to U.S. growth stocks from 2000-2006. However, in the late 90s, large U.S. growth stocks, led by the technology sector, were on a tear. All investors heard on the nightly news or the infamous cocktail party was about whatever.com that tripled yesterday.
Our investment objectives are always to provide our clients with a well diversified long term portfolio. I know it sounds like you have heard this before, but I literally saw investors with a Large Cap Growth fund, an Aggressive Growth Fund and a Technology Fund in the late 90s and considered themselves diversified. Even in more sound cases, good small cap international allocations are often neglected, and there is generally an enormously excessive bias towards U.S. large cap stocks.
Thus the problem with the nightly news. It looks like your neighbors portfolios. And in times, like the late 90s, when that particular asset class is outperforming most others, the risk that investors will bail on a soundly diversified portfolio for the hot stock pick of the day is a dangerous one.
The last risk is the most important one of all.
It is, quite simply, the risk that you will not have enough money to reach your goals. Whatever that means to you. Are your goals for a comfortable retirement? Then the risk is that you retire comfortably, but start depleting your money, find that you need a reverse mortgage to continue, and ultimately rely on the kids. Is your goal pay for your kids' college education? Then the risk is that you don't have enough to do so, and they have to take out loans, or even worse, don't go.
The biggest danger with this risk is that it can sneak up on you. Some of the risks that I mentioned in my last post about risk, really apply here. While everyone is checking their monthly brokerage statement to see if their balance is lower this month than last month, nobody stops to check if that amount will buy as much today as it did yesterday. In other words, inflation (purchasing power risk) is a greater long term risk of causing you to not reach your goals than the systematic risk of markets declining.
What does that mean? Let's say inflation averages 4% over the next thirty years. That means that in the year 2038, you will need $324.34 to buy the same pair of shoes that cost $100 today. If your money doesn't grow as fast, you have literally lost money. Slowly, and what will appear painlessly, but most assuredly, money will have been lost.
I say that it will appear painless because the pain is very real, despite never once seeing a statement that shows a lesser value than the month before. I used to deal with these customers all the time when I worked at the bank. This was in the early to mid-nineties. These were customers who never invested in a stock or mutual fund in their lives. The Great Depression and the Crash of 1929 wasn't something they read about, it was something they lived through.
"I used to get 14% on this savings account," they would lament. "$160 in interest? Boy, I remember when that was a lot of money. Will you be kind and make me a photostat copy of this check? You're a nice young man." This statement embodies purchasing power risk. It is the silent risk that can keep you from reaching your long term goals. Also, who remembers what a photostat copy is?
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