Jason ROSEN
05/12/07
05/12/07
The Risk of Investing for Safety
Are you managing risk in your portfolio? Tim Hanson for the Motley Fool addressed this question in article dated May 3, 2007.
Investing always involves some risk. Even the "safe" investments like CD’s and T-Bills have some sort of risk associated with them. Many people think of risk in terms of volitility, often expressed as beta. But what Tim Hanson’s article talks about is the hidden risk of inflation.
...
Often when I am asked to look at a client’s portfolio I find that a large portion of the portfolio is invested in these “safe” investment vehicles. Asset preservation is fine but you have to consider that inflation has an impact on the real return of that investment. In effect, an investment that fails to keep up with inflation is simply locking in your loss. No one invests to have less money, do they?
So is volatility risky?
Not necessarily as risky as keeping up with the cost of living.
Not necessarily as risky as keeping up with the cost of living.
The article suggests that beta is not the end all - be all measurement of a good stock. It goes on to suggest that a stock that performs better than the market average may very well have a share price that is not closely correlated to the market trends. In other words, the stock may go up or down disproportionately to the rest of the market. But who cares about volatility if the stock is outperforming? The point is that you have to look at the performance as well.
In fact, there is more risk in losing purchasing power to inflation than volatility. Historically, you need to make 3% annual return after taxes just to break even. Add to that the annual increase of the cost of a home, cars, education or anything else that outpaces inflation and you soon realize that your investment dollar has a formidable task ahead of it.
So in a nutshell, you are going to have to do better than that "safe" CD. Your CD is now starting to look, well….risky with a capital R.
So how do you beat inflation? You invest in the stock market. Stocks returned 11.2% annually from 1952 to 2002 and edged out inflation by 7% for the same time period. In comparison, bonds only returned 6.8% per year for the same period, meaning the spread over inflation was only 3%.
Still like the security offered by fixed income investments?
One last point to help it all sink in. In the 50 years between 1952 and 2002 bonds suffered for 16 of those years. In the same period, stocks were down 13 years.
So the recommendation is that if you are concerned about inflation risk (and you should be) and you have investment money that you can keep invested for 3 years or more, then look for stocks that are likely to outperform the market average.
Time horizons are a very important consideration when determining how much volatility and risk a particular investor can absorb in the name of performance. Obviously the closer you are to counting on this money for your immediate needs the more you should seek stable savings vehicles.
1 comment
Comment feed for this post