I recently told a colleague I have a distribution deal for a financial television show that I have been working on for more than a year. His immediate response: “I would approach this project very cautiously.” I am sure he felt he was being reflective and analytic – traits we all admire.
My reaction was quite different. Trying to launch a television show of any genre represents a significant effort of time and money, with little possibility of success. If I had proceeded cautiously, I never would have initiated this project and wouldn’t have experienced the possibility (much less the reality) of achieving it.
What does this have to do with investing? Caution is part of the mantra disseminated by the financial media every day. This recent headline from Fox Business is illustrative: “Caution: Rising Fear Gauge Should Give Investors Pause.”
With so many experts predicting a 2008-style correction in the markets, is this the time to exercise caution and flee to the safety of high-quality bonds or even cash?
Investing based on the predictions of marketing pundits is more akin to gambling. There is precious little evidence that anyone has the expertise to predict the direction of the markets. If your allocation to stocks exposes you to so much risk that you could not withstand a prolonged (3 to 5 year) market downturn, you need to reduce that allocation. You should do so not because you are relying on the prediction of a market seer, but because your portfolio is too risky for you. There’s a big difference.
Your ability to take risk has a profound effect on your expected returns. If you cannot take any risk, you will be limited to the return of Treasury bills, which have barely kept up with inflation over the past 70 years. Factors that can affect your ability to assume risk include your age, whether you are working and could replace financial losses and your psychological ability to withstand the stress of a serious downturn in the market.
Inflation and the loss of purchasing power are meaningful risks that are often overlooked by those preaching caution. According to an article by Richard Barrington on Investopedia, “At an average inflation rate of 3 percent per year, the value of a portfolio is cut in half every 23 years or so.” However, if you are unlucky and run into a period when inflation is greater than average, the impact can be devastating. Investopedia noted that during the 10 years ending in 1982, inflation averaged 8.7 percent annually, causing the price of items to almost double within that decade.
Finally, what you think may be a low-risk portfolio may actually be less conservative than a portfolio with greater allocation to stocks and higher expected returns. According to calculations by Jackson Thornton Asset Management, you can do this by substituting shorter-term fixed-income assets for longer-term government bonds.
I am not suggesting that you “throw caution to the wind,” just that you put caution in the right perspective.
Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth advisor with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His next book, The Smartest Sales Book You’ll Ever Read, will be published March 3, 2014.
The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.