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The Four Letter Word of Personal
Finance Justus Morgan |
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Perhaps
you or someone you know can relate to the following story I’m about to tell
about a gentleman who recently retired and declared he did not want to
experience any losses in his investment portfolio. To him, the four letter
word of personal finance was risk. After
working for forty years and earning a regular stream of income, the
gentleman, who we’ll call Mr. Risk-Averse had accumulated a sizable nest egg
from which he would begin to draw income for the next thirty years. He was
apprehensive and concerned about losing any of his money which he had worked
so hard to accumulate. Mr.
Risk-Averse was focused on investment or market risk in his portfolio which
we can all relate to as the news media reports the closing value of the stock
market and its change every day. Mr. Risk-Averse was hyper-sensitive to the
value of his investments at the end of the day because of his fear of loss. While Mr.
Risk-Averse was focused on market risk, he was unaware of two more risks
which could prove to be just as detrimental to his financial security, namely
inflation and longevity risk. Each of these risks is just as serious but
occurs on a more gradual basis and therefore is less dramatic on a daily or
even annual basis. Inflation
risk is the reduction in the purchasing power of a dollar over time. Most of
us know that inflation has averaged 3-4% per year but don’t recognize how
this can significantly reduce our ability to buy goods and services a decade
or more into the future. For
instance, you would need approximately two dollars today for every dollar you
received in 1984 to buy the same amount of goods or services. Or imagine
$50,000 of income in 1984 would require almost $100,000 today for the same
goods and services. Every two
decades, your purchasing power is almost cut in half which is the equivalent
to losing half your money. While Mr. Risk-Averse may not have had any
negative returns on his investments, his failure to keep up with inflation
could have just as serious of a consequence. This is one of the fallacies of
the old “live off the interest and don’t touch the principal” investment
strategies. If your principal doesn’t grow, neither does your ability to
withdraw more income. The other
type of risk that occurs gradually is longevity risk or the chance of
outliving your money. When Mr. Risk-Averse first retired, he had no idea that
his desire for no investment losses dramatically increased his risk of
running out of money twenty years in the future. Unless Mr. Risk-Averse plans
to withdraw relatively low amounts from his portfolio, he runs a high risk of
exhausting his money before the end of his life because he must continue to
draw higher amounts from his portfolio to keep up with inflation. So what
is Mr. Risk-Averse to do? The first step is to recognize that risk is
unavoidable. His initial desire to eliminate investment risk only increased
inflation and longevity risk. In order to overcome each of the three risks
outlined, Mr. Risk-Averse needs to adopt a balanced strategy with multiple
goals in mind. While there are ongoing efforts to develop a single product to
solve all the problems, we are not there yet. In the
meantime, a variety of options could make sense for Mr. Risk-Averse including
the use of stock investments for higher returns (provided they are
diversified), immediate annuities to reduce the chances of running out of
money (assuming the costs are low) or the use of inflation-adjusted
investments that outpace inflation on an annual basis (such as Series I
Savings Bonds). While Mr.
Risk-Averse doesn’t need to become Mr. Risk-Taker and gamble with his money,
he also cannot ignore the steady erosion of the value of his money or the impact
of increased life expectancies of today’s retirees. |