Unless you have more money than you know what to do with, you need to be aware that
there’s much more to worry about than just the risk involved in investing in the stock
market.
On occasion (and more often than you might expect), we have clients who are extremely
risk averse. When they come to us, all their money is in money market accounts,
checking and savings accounts and CDs (certificates of deposit). They often have large
balances in checking/savings accounts paying less than one percent in interest,
annually.
When we help clients develop their target investment portfolio, we spend considerable
time explaining the various kinds of risks in investing. These include: systematic and un-
systematic risk, market risk, inflation risk, interest rate-risk, exchange rate risk,
reinvestment risk, business risk, financial risk and default risk. Since it would take
considerable time to explain all of these risks, we will focus on perhaps the two greatest
risks an investor faces: inflation risk and market risk.
Market risk results from changes in investor preferences as well as social, economic and
political events. Every day the news commentators try to explain the market’s gain or
loss by some “happening” of the day. We often chuckle at their “reason of the day”.
One of our favorite cartoons shows a couple watching the business news on TV. The
caption reads: “Stock prices fell sharply today on the fear that stock prices would fall
sharply.”
The other major risk to fear is inflation. We are currently reading daily of food shortages
worldwide. Commodity prices have risen sharply with oil topping $ 120 a barrel and
predicted to reach $ 150 by summer’s end. Gasoline is predicted to hit $ 4.00 a gallon
this summer.
At even a modest 3% inflation rate, the “Rule of 72” tells us that the cost of living will
double in just 24 years. (Note: The Rule of 72 can be used to estimate how long it takes
to double your money given a certain rate of return. For example, if you can earn 6%
annually, just divide 72 by 6 to determine how many years it will take to double your
money – 12 years). So, if you are spending $ 40,000 a year now on expenses subject
to 3% inflation, you’ll need $ 80,000 a year, 24 years from now!
Losing purchasing power due to inflation can be just as devastating to your retirement
plans as a big market downturn. The difference is that markets recover while prices
continue to rise. Therefore, those of you who avoid investing in equities could be in
substantially more trouble than those who are aggressively investing in the market.
Many people who avoid investing in the market have been told that they need equities in
their portfolio to keep up with inflation, yet they still choose to shun the market. Why do
they do this? We can get some insight from the book Your Money and Your Brain
(Simon and Schuster, 2007), by Jason Zweig, a senior writer for Money Magazine. Mr.
Zweig points out that people are extremely averse to suffering any kind of loss. Worse
still are losses that result from them taking some specific action, such as buying a stock
or mutual fund. Therefore, they are more comfortable doing nothing (e.g. keeping all
their assets in safe bank accounts and CDs), even though it may result in an even more
disastrous consequence, a substantial reduction in their purchasing power. They need
to realize that by “doing nothing” they are really avoiding an alternative (i.e. taking an
action) that in all likelihood will be good for them in the long run.
They need to understand that if they invest in a broadly diversified portfolio containing
both fixed income and equity asset classes, they will do far better over the long run than
if they invest only in money market funds, bank accounts and CDs. Broad diversification
lowers risk and increases returns. Low cost, tax efficient mutual funds, exchange traded
funds and index funds can minimize expenses and taxes. Yes, the broadly diversified
portfolio will experience ups and downs. But over the long run it will better protect you
from the myriad risks that investors face.
David C. Patterson, CFP® and Erin Patterson, CFP® are the owners of Patterson Advisors, LLC, a fee-
for-service-only financial advisory firm. Patterson Advisors, LLC is a Registered Investment Advisor,
registered with the State of Michigan, helping clients in Waterford, Clarkston and Royal Oak, Michigan
as well as other Oakland County, Michigan communities . Visit www.pattersonadvisorsllc.com for more
information or call 248-674-2108.
Published in the Oakland Insider, May, 2008
Risk Has Many Faces
By David Patterson and Erin Preston (formerly Patterson)