Time To Learn To Dance

“Life Is Not About avoiding the storms. It’s about learning to dance in the rain." Quote of Unknown Origin.

Are You Ready To Dance? I stole this quote from a friend who doesn’t really recall where he heard it. The beauty of the quote is that it can apply to a variety of life situations. I have been thinking a lot about investment risk lately and I wanted to share some of these thoughts with you.

Let’s Just Not Take Any Investment Risk. I have heard that statement a lot lately. Do you think you can avoid risk by putting all your investment capital in one year, certificates of deposit? In the early 80’s, you could get 11% on a one year CD. A million dollar nest egg, spread around in $100,000 increments would give you an income of $110,000 per year and be totally insured against loss by an agency of the federal government. If you stayed with that philosophy for the next 30 years you would find that your income dropping $30-40,000 per year at current rates of 3-4%. Of course, you would still have your million dollar principal but you could find your lifestyle significantly curtailed by the reduction in income. This type of risk is called
reinvestment risk.

How About a 30-year Government Bond? You could have been guaranteed an income of about $120,000 a year for the next 30 years and you could always get your principal back by selling the bond on the secondary market. Sounds good doesn’t it? But what if rates had increased to 16% instead of dropping? In 2 years your 30-year bond would be worth only $753,000. This type of risk is called “interest rate risk.” Even if you could have afforded to leave the money invested for the full 30 years, inflation would reduce the purchasing power of that million dollars to $308,000 (assuming an average inflation rate of 4%). This type of risk is called purchasing power risk.
Let’s Just Put It All In Gold. While that may sound like a ridiculous statement, let me assure you that I have had clients who made that very suggestion. Given the hype you hear on radio commercials today, you would be tempted. For example, if you had put a million dollars in gold at the average prices 9 years ago, you would have just over 4.1 million, a hefty return of almost 18% per year. These radio commercials tell you that and try to alleviate your fears of risk by saying “Gold has never been worth zero.” What a comforting statement that is. What they don’t tell you is that if you had bought gold in 1980, almost 30 years ago, your million dollar investment would be worth just $2 million, a return of 2.4%. Even worse, if you had panicked and sold your gold 20 years later at the average price of $279 per ounce, your million dollars would have been just over 455,000, a compounded negative 4% per year. I call this type of risk, timing risk. The worst thing about this type of risk is that, in times of high prices, you will be bombarded by radio commercials and sales calls telling you about the high returns available and by the time they say “past performance is no guarantee of future results” you are hooked When prices are lower, these sales people go back to their regular jobs at convenience stores or driving taxis. These market forces direct you to buy high and sell low, and many investors fall into this trap. For example, mutual funds have to tell you their average return over a long period of time. Unfortunately, most individual investors fail to get close to that return because of the natural tendency to buy when prices are high and sell when prices are low.

Let’s Take A Look At the Stock Market. Pretty scary isn’t it. Most of us have suffered substantial losses in the past 2-3 years. Again, it’s a matter of timing. If you would have bought stocks in 1980 and received the average return of the S&P500 average. Your million dollars would have received a compounded return of 7.87%. Added to this would be an approximate dividend yield of 3% (Average of 53 years, best number I could find). If you had invested a million in 1980, you could sell out now for around 9.7 mil. In addition, you would have received approximately $30,000 in dividends that you could reinvest or spend each year. Just like in the gold investment, you would have timing risk along with market risk and some purchasing power risk.

What About Real Estate? Unlike the stock market, there is little in the way of statistical data on real estate returns. The nearest thing I could find was the Case-Shiller Indices that show the nationwide average returns on investment in single family housing was 9.31% from 1998 through 2007. This compares with 5.91 for the stock market. It should be emphasized that this was a very favorable period for housing. It should also be noted that Case-Shiller doesn’t give much detail on whether these returns are leveraged or whether they include rents and professional management costs. For the purposes of this review let’s just say that real estate offers an alternative and could part of any investment portfolio. Risks are market risk, timing risk, and some management risk.

None of These Investments are “Bad,” The main purpose of this column was to let you know that there are real risks involved with any investment vehicle; however, each one of these investments are appropriate for certain purposes. The trick is to pick the ones that are right for your risk tolerance and unique needs. Like the quote at the beginning implies, no one can predict the future. What we have to do is design a strategy, monitor that strategy, and make changes when necessary.