The Allure and Myth of Safety
In Homer’s Odyssey, a wayward Odysseus and crew voyage past an island of beautiful mermaids called Sirens. The Sirens sing the sweetest of songs, the ancient equivalent of “Call Me Maybe”, bewitching passing sailors. Those mesmerized are blind to the bones littering the island, for the Sirens were in fact monsters that devoured their hapless victims.
When approaching retirement, there are few Siren songs as strong as the promise of safety. It compels retirees to flock toward guaranteed interest products such as cash, CDs or money markets. When stocks and bonds toss your nest egg about like a ship on a stormy sea, as they did in October, you’ll hear the Sirens calling.
For there on the horizon lies a seeming oasis, a place of serenity and tepid waters. The Sirens at your bank beckon you to their safe shores. You’ll buck against all restraint to answer the call. Why risk your retirement savings when you can keep your principal perfectly safe?
Mesmerized, you fail to see the bones littering the island.
Conservation of Risk
There’s no such thing as a free lunch. Similarly, there’s no such thing as a risk-free investment. Any place you park a dollar offers a benefit at cost. A reward for a risk. A pro for a con. There are no exceptions. Like energy, risk cannot be destroyed, it can only change form. A scientist might call this principle the conservation of risk.
Surveys show that the number one fear for retirees is running out of money. Logically, losing your savings in an epic market crash might seem like the surest path to disaster. Before you rush to throw your savings into a guaranteed interest rate investment, understand you’re just trading one risk for another. Specifically, you’re trading market risk for inflation risk.
Inflation: The Con Man
The things you spend money on get more expensive each year. That’s inflation. And it can be every bit as harmful as a market crash. But market crashes are clumsy like a thug. They hit hard, immediately commanding your attention and often incite panic. But a thug can only shake you down once or twice before you’ll change your behavior to steer clear of their abuse.
Inflation is more clever, like a con artist. It doesn’t hit hard or all at once. It presents itself as a friend and robs you a little at a time. By the time you get wise it’s too late; the money Is gone.
Guaranteed interest accounts feel good. Every time you check your balance it’s a little higher than it was before. It never goes down. Sure, you’re not making much, but at least you never lose, right?
InflationData.com quotes inflation over the last century as having averaged 3.22%. As of this writing, Bankrate puts the national average for 5 Year CDs at about 1.29%. Adjusted for inflation, that CD is losing 2% in purchasing power annually. Put all your money here and it would be no different than taking an annual 2% pay cut. The con man is at work.
The chart above compares an annual budget of $5,000 inflating by 3.22% to a “safe” source of income growing by 2% (a real return of -1.22% annualized). After just 5 years this hypothetical retiree has lost 15% of their purchasing power. By year 20 they’re off 50%!
Quote the Siren, “But you would have been better off in a CD paying 2%!”
Here’s the problem: inflation just isn’t scary enough. People are far more worried about market crashes. Even though inflationary effects can be every bit as disastrous to a retirement plan, the market dropping 20-30% all at once feels like a bigger risk. This fear is mostly misplaced.
Have you ever known someone who is deathly afraid of air travel but has no problem cruising to Walmart in their SUV? Statistically, air travel is far safer. You’re approximately 100x more likely to be killed in a car than an airplane. I get it, flying at 35,000 feet feels riskier, but that’s the point: people are terrible at assessing risk.
It’s been a very good decade for markets and investors. Most readers have more money now than ever. But when the market dropped 7% in October, we were reminded that markets are volatile. People got scared. The Sirens called.
A conservative client that had come on board in September was flabbergasted. He wondered if he would be better off in a CD paying 2%. It’s never fun to start a new planning relationship on the cusp of a market drop, but it happens.
Over the last hundred years, S&P 500 performance has been negative in half of all days, months and quarters. It’s negative in one of every four years! That sounds plenty scary, providing plenty of opportunity to doubt the trajectory of your financial plan. Should we answer the Sirens and go for that 2% guarantee?
As noted, a 2% guarantee will beat the market in half of all short time periods. But over longer periods, this strategy becomes like a broken clock: right on rare occasions, but mostly flat wrong.
Since 1976, a portfolio allocated 60% to US stock and 40% to US bonds would have been positive 83% of the time. But that means there were 7 gut wrenching years of loss. Sounds troubling, until you take a few more steps back. The blended portfolio was negative in just two rolling 3-year periods. Not a single five- or ten-year period includes a negative result.
The moral of the story? Time and patience are your friends. And get this, the average annual rate of return on this blended portfolio is 10.76%, beating inflation 3 times over!
Being in the market is a lot like boarding an airplane. It might feel dangerous, and there’s bound to be turbulence along the way, but it’s near certain you’ll make it to your destination safely. All you have to do is sit and watch a movie. Just chill!
The Only Thing We Need to Fear is Fear Itself
The media loves market crashes. As the saying goes, if it bleeds, it leads. The next time markets tumble, it’ll be made to sound like the end of the world. Remember, the news is in the business of creating revenue for advertising partners. Panic creates a lot of revenue!
But imagine for a moment that the media was honest (difficult, I know). A market tumble be worthy of note, but you’d be reminded that in the long run, our current troubles won’t matter much. It’s panic and flight to illusory safety where true trouble lies.
Inflation is here to stay. To combat it, you must tolerate a certain amount of risk. At times the path will be bumpy, scary even. But let time take its course. Plug your ears, don’t listen to the Sirens. We’ve planned for this.