What we talk about when we talk about risk

Everybody’s financial situation — age, income, saving rate — is different.

But every retiree, early or late, aspiring or actual, has the same, simple investing imperative: We must preserve and grow our purchasing power in real terms in order to finance decades of future consumption.

This sounds simple (which it is) and obvious (which it isn’t).

The Declining Value of Your Dollars

Let's assume you're forty years old. Every week, you buy a six-pack of your favorite microbrew for $10. You have $520 in savings that will buy you your weekly six-pack for all of 2019. Life is good.

Here, for instance, is GRS founder J.D. Roth with a $10.19 six-pack of his favorite beer, which he's drinking while he edits this article:

J.D. with a six-pack of his favorite beer

Now, let's assume that the cost of this six-pack increases by 3% annually — which is a reasonable estimate of inflation. Every year, your $520 in savings buys you 3% less beer.

In thirty years, when you’re seventy and still enjoying your suds, that six-pack that costs you $10 now will cost you $24.27, which is a $1,262 annual expense if you continue to buy a six-pack a week.

In other words, your $520 in savings has to increases by nearly 145% to $1,262 over the next thir[s]ty years to merely maintain — let alone increase — your current beer consumption.

It gets worse.

Even if everything goes according to plan and your beer money grows from $520 in 2019 to $1,262 in 2049, you’ll need to sell $1,262 worth of your investments to get the cash for your beer. That will trigger a $750 taxable gain, and at a 25% federal and state tax, you'll have to pay approximately $188 in taxes. Your beer money is now approximately $1,074. This only buys you 44 six-packs of beer in 2049, whereas you were consuming 52 six-packs in 2019.

In other words, due to inflation and the taxation of nominal gains, you’ll be poorer, with a lower standard of living, thirty years from now.

This bears repeating: A 3% pre-tax return on your investments will not preserve, let alone grow, your current standard of living.

Why Bonds Are Riskier Than Stocks

By coincidence, the 30-year Treasury is currently yielding just over three percent.

The 30-year Treasury is widely perceived as a very safe investment, backed by the full faith and credit of the United States government. However, as demonstrated, owning a 30-year Treasury is in fact very risky (more on how I define this term later), because after taxes and inflation, a holder of a 30-year treasury is virtually certain to see his real purchasing power erode over the thirty years that he holds the bond.

Confused about bonds? Here's a short article that explains how bonds work.

People don’t perceive bonds as risky because most investors define risk in terms of volatility. And, it's true that the prices of bonds are not volatile. If you buy a 30-year Treasury and hold it until it matures, its market price doesn’t matter. You simply clip the coupon and get your principal back in thirty years.

Unlike stocks, bonds offer far fewer of those price fluctuations that are terrifying to investors. As a result, bonds are perceived as “safe”.

But, recall the purpose of investing. You don't invest in order to minimize your portfolio’s volatility or to reduce the probability of paper losses. The goal of investing is to preserve and grow your purchasing power in real terms so that you can finance decades of future consumption.

Viewed in this light, the 30-year Treasury is actually quite risky. If you buy a Treasury bond, your return is certain, and your volatility is quite low (or even nonexistent). At the same time, your purchasing power is certain to diminish over the next thirty years. You’re going from drinking 52 six-packs in 2019 to 44 six-packs in 2049, which is a 14% reduction in your standard of living.

The Difference Between Volatility and Risk

The 30-year Treasury example illustrates a crucial concept; namely, the distinction between an investment’s volatility and risk. People often use these terms interchangeably, but they're very different.

  • Volatility is a measure of how prices change over some short-run period.
  • Investment risk, in contrast, is seeing your real purchasing power decline (after taking into consideration inflation and taxes).

Since you’re planning decades out — and quite possibly still working and living off of earned income, not investments — volatility doesn’t matter much to you or your financial future. But risk is vital.

You likely have decades of investing ahead of you, so even five years of price fluctuations are largely irrelevant to your long-term net worth and goals. The volatility, while painful when you’re living through it, is actually meaningless in the long-run, mere paper losses that will reverse over the decades you hold the investment.

Conversely, if your real purchasing power erodes 14% because you own a 30-year Treasury, this is a hugely significant permanent reduction in your standard of living, with no chance of ever getting that purchasing power back.

That is true risk, one you should avoid at all costs.

How to Avoid Investment Risk

This distinction between volatility and risk isn’t merely academic. It goes to the heart of investing and asset allocation.

Many investors think buying bonds is “safe” and buying stocks is “risky”. However, when risk is properly defined — as not merely volatility, but rather a diminution of real purchasing power — it becomes apparent that bonds are actually extremely risky assets while stock are actually the safer asset.

This assertion inverts the traditional notion that there is a fundamental trade-off between risk and return.

The only way to avoid investment risk (as I define it) is to purchase public stocks, which is the only asset class accessible to small investors that will appreciate in real terms over the next several decades. Equities offer investors low-risk and high return.

Bonds, in contrast, create tremendous portfolio risk, in the form of a negative real return. They represent return-free risk over a long-period of time.

Few investors realize this, and imagine they're being prudent when they invest in bonds or hold cash. In fact, they aren’t protecting anything. They're merely locking in a guaranteed loss.

[See also: Where risk lies in a balanced portfolio at A Wealth of Common Sense]
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Cindi
Cindi
1 year ago

What is the goal here? To drink a certain brand of beer every day or to have a beer every day? I always considered brand loyalty to be a moot point. People go where the best deal or trend is. Otherwise, they’d be still drinking Schlitz and MadDog 20/20. I understand about brand loyalty however, since I’m an avid Apple Computer fan. But there is always a different way through the maze and you can still keep your earning power intact. For instance, I have a brand new iMac but I need a laptop for travel. I balked at the… Read more »

dh
dh
1 year ago
Reply to  Cindi

Super great points.

Steve
Steve
1 year ago
Reply to  Cindi

If you switch to drinking your non-preferred brand of beer, that is a lowered standard of living. You can squeeze out a little time doing that. Another 10 or 20 years, and you’ll either have to drink some pretty bad beer, or drink less of a decent brand.

IN
IN
1 year ago
Reply to  Steve

The real question is can you RISK the VOLATILE reaction of your taste buds from switching to lower grade suds. Bitter beer face might hinder ones ability to wet the whistle thereby preventing the whistle. Hehe

Nato
Nato
1 year ago
Reply to  Cindi

The beer was really not the focus here. It was just an everyman’s illustration of inflation.

“The goal” was how to combat inflation of 3% on your net worth. The author’s conclusion is that stocks are “safer” than bonds at beating inflation.

Lowering your standard of living would also make/save you money, but that’s an entirely different topic. Obviously you can pursue both goals simultaneously, unless you’re trying to have your beer and drink it too (like JD).

RichardP
RichardP
1 year ago
Reply to  Cindi

Sure, you can drink a cheaper beer, but the point is that all prices will be rising due to inflation. The cost of electricity will go up. Gas or heating oil will become more expensive. And yes, you can be more efficient in your usage, but only up to a point.

Inflation WILL erode your purchasing power. This is indisputable. The question is do you make plans in advance to compensate for it, or adjust your lifestyle downward when that becomes your only option.

IN
IN
1 year ago
Reply to  RichardP

What if a person bought 30 years of beer at once and put it in their walk in fridge? Risk and volatility has disappeared assuming the power stays on.

JanBo
JanBo
1 year ago
Reply to  Cindi

I remember when gas was $.25 a gallon. I need to be prepared for it to be $10. I figure I might have another 40 years. Keeping up and beating inflation will be tough when SS starts to collapse. Good tips here Cindy.

IN
IN
1 year ago
Reply to  JanBo

The tough part about something like gas is one year gas might be $5 a gallon and the next $2.25 followed by $3.50 the third year. There are a million forecasters that predict prices into the future and only a few are correct. Most of the few that were correct, were correct through dumb luck. Look at what people predicted a barrel of oil would cost 20 years ago. The numbers were crazy high with some predicting $300 a barrel. Then came Texas and North Dakota completely changing the game with the US producing more than ever thereby changing the… Read more »

Steve
Steve
1 year ago

“Stocks aren’t risky” is the new “your house isn’t an asset.” You can only make that kind of statement by redefining what words mean.

Also, modern portfolio theory says that you can get the same return with lower risk, or a higher return with the same risk, by mixing in some bonds with your stocks and rebalancing regularly.

Pete
Pete
1 year ago

This is the explanation I’ve needed for a while to explain it to people. Thank you! I get very odd looks when I say that I have always been 100% stocks when my fund choices allow. I still have at least 11 years until I’ll be touching them (16 on the big accounts) so I don’t see any reason to lose long-term gains for some type of perceived stability. Sure, on paper I’ve been down huge in ’01 and ’08 but I didn’t touch it and I’m way ahead today compared to a traditional mix of stocks and bonds. I’ll… Read more »

IN
IN
1 year ago
Reply to  Pete

08-09 killed my 401k. I didn’t touch mine either and it is now much higher than before the big drop. History shows that markets go down and markets go up.

jon
jon
1 year ago

I’ve always been perplexed when financial planners ask clients how much risk they can tolerate. Its like asking someone how much pain they can tolerate. I don’t wake up in the morning wondering how much pain I can tolerate today. I don’t want to take any risk with my portfolio. Nobel prize winning Economists and PHd’s cannot accurately forecast inflation or ROI within a year. Trying to forecast inflation and ROI over 30 year horizons is laughable. The other main problem with asset allocation and 4% rule based type withdrawal schemes is that a 50% drawdown over a few years… Read more »

Pete
Pete
1 year ago
Reply to  jon

Rentals are pretty awesome. And while crazy things can happen, that is something I should probably consider. Although I seem to be too lazy.

mike
mike
1 year ago

Good post

nikdanut
nikdanut
1 year ago

Good points/analysis. But what if you had a mortgage bond (1st position DOT) secured by real property, the loan made @ 50% LTV with a 10% interest rate on a 1 year note? would you still prefer stocks…overall?

Fay
Fay
1 year ago

The main point is that you guys should all become proactive and investigate what stocks/bonds mean and not just believe what JD states. There is always a good/bad/indifferent view to each senario and it’s up to each individual to make up their own minds which way they want to go…………….that’s how everyone can gain knowledge. maybe everyone should rememeber this and not just look at this as price of beer as stated by Nato

Luke Calvano
Luke Calvano
1 year ago

If you’re looking to grow your wealth, you need riskier assets like equities – that’s just the price you pay for growth (and volatility IS a risk IF cash flows are involved, since sequence of returns matters once cash flows are introduced… if you aren’t touching your account during accumulation, then volatility is a psychological issue vs. a mathematical one). If you want to preserve purchasing power, TIPS (Treasury-Inflation Protected Securities) are a good option. They are inflation-linked bonds that pay a nominal yield – meaning they pay (slightly below) govt bond yields plus inflation expectations… TIPS are a good… Read more »

Christopher Prosser
Christopher Prosser
1 year ago

What about Sequence of Return Risk? I have investments in bonds and cash so I can weather 6 years of crappy returns from equities. Being forced to sell stock in a down year can destroy your future wealth, which is a real risk towards future purchasing power.

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