{"id":236542,"date":"2018-11-07T05:30:00","date_gmt":"2018-11-07T13:30:00","guid":{"rendered":"http:\/\/getrichslowly.org\/?p=236542"},"modified":"2023-12-05T14:20:31","modified_gmt":"2023-12-05T21:20:31","slug":"investment-risk","status":"publish","type":"post","link":"https:\/\/www.getrichslowly.org\/investment-risk\/","title":{"rendered":"What we talk about when we talk about risk"},"content":{"rendered":"

Everybody\u2019s financial situation — age, income, saving rate<\/a> — is different.<\/p>\n

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.<\/strong><\/p>\n

This sounds simple (which it is) and obvious (which it isn\u2019t).<\/p>\n

<\/span>The Declining Value of Your Dollars<\/span><\/h2>\n

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<\/em>.<\/p>\n

Here, for instance, is GRS founder J.D. Roth with a $10.19 six-pack of his<\/em> favorite beer, which he’s drinking while he edits this article:<\/p>\n

\"J.D.<\/p>\n

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.<\/p>\n

In thirty years, when you\u2019re 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.<\/p>\n

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.<\/p>\n

It gets worse.<\/p>\n

Even if everything goes according to plan and your beer money grows from $520 in 2019 to $1,262 in 2049, you\u2019ll 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<\/em> six-packs of beer in 2049, whereas you were consuming 52 six-packs in 2019.<\/p>\n

In other words, due to inflation and the taxation of nominal gains, you\u2019ll be poorer, with a lower standard of living, thirty years from now.<\/p>\n

This bears repeating: A 3% pre-tax return on your investments will not preserve, let alone grow, your current standard of living.<\/strong><\/p>\n

<\/span>Why Bonds Are Riskier Than Stocks<\/span><\/h2>\n

By coincidence, the 30-year Treasury is currently yielding just over three percent<\/a>.<\/p>\n

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.<\/p>\n

Confused about bonds? Here’s a short article that explains how bonds work<\/a>.<\/p><\/blockquote>\n

People don\u2019t 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\u2019t matter. You simply clip the coupon and get your principal back in thirty years.<\/p>\n

Unlike stocks, bonds offer far fewer of those price fluctuations that are terrifying to investors. As a result, bonds are perceived as \u201csafe”.<\/p>\n

But, recall the purpose of investing. You don’t invest in order to minimize your portfolio\u2019s volatility or to reduce the probability of paper losses. The goal of investing is to preserve and grow your purchasing power<\/strong> in real terms so that you can finance decades of future consumption.<\/p>\n

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\u2019re going from drinking 52 six-packs in 2019 to 44 six-packs in 2049, which is a 14% reduction in your standard of living.<\/p>\n

<\/span>The Difference Between Volatility and Risk<\/span><\/h2>\n

The 30-year Treasury example illustrates a crucial concept; namely, the distinction between an investment\u2019s volatility and risk. People often use these terms interchangeably, but they’re very different.<\/p>\n