Sunday, March 27, 2016

What’s a conservative investment? It all depends on who you ask.

As a financial advisor I would frequently have clients who told me they were fed up with the volatility of the stock market and were now looking for more 'conservative investments'. As it turns out, the definition of conservative can vary widely.

Often when people think of conservative investments what comes to mind are things like CDs and investment grade bonds. These investments provide predictable and sometimes guaranteed returns, albeit at much lower rates than historical average returns from the stock market. An additional challenge for the past several years has been that when interest rates are so low, you end up losing purchasing power as inflation eats away at the value of your 'conservative' investments. How's that for conservation?

Wind creates waves, but can also be captured by a sail to propel a boat across great distances. In order to advance a boat in the absence of wind, a sailor must exert significant energy. Volatility in the stock market is like wind. The greater the wind (risk), the greater the speed at which your boat can go or the rate at which your investments can grow. If you can stomach the volatility and use it to your advantage by buying and holding, you can end up much farther ahead than if you stick to calmer waters (low volatility investments) and rely on rowing. If you insist on sticking to low risk investments, be aware that you will need to save at least double what you would need to save if you were willing to take a little more risk.

I'd like to make the argument that if you're truly looking for a conservative investment, look no further than a diversified stock mutual fund.

What? You can't say 'stocks' and 'conservative' in the same sentence!

Here's a few reasons why.

  1. Long term, stocks outperform bonds and cash.

  2. Capital gains from investing in stocks are generally taxed at a lower rate than the tax rate for interest income from bonds or cash, further widening the gap in performance.

    • But hey, DIY$, my investments are mostly in retirement accounts so I don't pay taxes until I withdraw! (See reason #1.)

  3. Preserving purchasing power is much more important than preserving your original account balance. Inflation has been relatively benign in recent years but don't let that fool you. If we were to have 2% inflation for the next 10 years (slightly lower than average) and you're invested in a 10-year Treasury bond at 1.75% because it's "safe", you end up LOSING 0.25% per year in purchasing power.

The main argument against this line of thinking is the obvious fact that the value of a stock portfolio can go down and that there are no guarantees. There are a lot of insurance companies that are more than willing to take that bet and offer you guarantees through annuities, but be VERY careful with these. What would you say if an insurance company offered a guarantee that if you invested in the stock market for 10 years, they would guarantee you not lose money? Sounds great, right? All the upside potential of the stock market but without any of the downside risk! This is how these products are sold, but the truth is usually much more confusing.

For this type of guarantee, an insurance company will charge ~2-3% per year in management fees on top of ~1% in mutual fund management fees. If you cash out early, not only can you lose the guarantee, but you will also likely have to pay an early surrender charge that could be as high as 10-15%. If you really dig into the fine print too, you may also find that the guarantee has a monthly cap. So if they cap the gains at 2% per month, and the market earns 8.3% in a month (like it did in October 2015), you would have been better off just being invested in a regular mutual fund instead of in the annuity with caps on monthly gains. If you look back over time, there have been very few times where an investment in the stock market loses money over 10 years. The 2000s were often referred to as a 'lost decade', because the market ended the decade basically where it had started. If you had been paying 2% in insurance fees per year though, your investments would be down ~20% instead of unchanged.

It's a crazy world out there, but I am confident that with the right information, you can do it. Stick with stocks, and don't let a little choppiness cause you to jump off the boat or seeker calmer waters. Understanding what you're invested in can arm you with the confidence needed to ride through the storms that may arise. Just this year, the Dow has gone down and then up again by 2,000 points. The only way you've lost anything though is if you sold. Don't do it.

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