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The sky is falling!! Recession is guaranteed! The markets are having a fire sale but it’s too dangerous to buy! The headlines are good at generating fear and unease. Understandably, it’s a significant fire that is causing the sale: The Fed raising interest rates, inflation, a war in Ukraine, supply chain challenges and a lingering pandemic are all noteworthy crises! If you listen to chicken little, it’s Armageddon! This time is different!
When these fires happen, being in the stock market can feel like the riskiest place to be, especially for those nearing or in retirement. It’s natural for retirees to worry about risk. And in the short-term, having enough cash or similar conservative liquid investments on hand to cover approximately 2-3 years of planned cash flow, is important. But in the long-term, what’s the safest place to put your money for your retirement portfolio, cash or stocks?”
In this article, we’ll explore the difference between volatility and risk and then demonstrate just how risky cash and stocks actually are.
Volatility and Risk
“Have you given any thought to investing a portion of your excess (and rather large) cash position to stocks?” we asked a recently retired prospect who had a large portion of their wealth in what they consider a “safe” investment.
“Oh, no, I couldn’t do that,” they told us. “The market is crashing! This time is different! I’ll lose everything.”
This is a common response that we hear from some prospects. Most retirees consider money in the bank to be the safest investment. By keeping their money in cash, retirees avoid the risk they detect in investments like bonds or stocks.
However, there is a crucial difference between volatility and risk. Risk is exposure to the chance of loss. With a risky investment, you’re putting money into an investment that may permanently lose all its value. When you invest in a diversified portfolio of the greatest companies in America and the world, how likely will it be that all will permanently lose 100% of their value? I can tell you, not likely at all. And if it ever happens, we have much bigger problems to worry about than our investment portfolios!
Volatility, on the other hand, is how rapidly and dramatically an investment tends to change in price. Just because an investment is more volatile doesn’t necessarily mean that it is riskier in the long term. Volatility is only a concern to investors if they need money in the immediate or near-term future.
Cash: Is It Really a Safe Haven?
Conventional wisdom has taught retirees that they have a limited runway to withstand market volatility. As a result, they love to believe that they can put all their money somewhere they perceive to be safe.
With cash assets, you won’t lose your money, and in fact, it still grows. For example, if you invested $1 in a savings account, bank CD, etc. in 1926, that $1 would be worth $21 dollars ninety years later. On the surface, it sounds appealing. However, this doesn’t tell the whole story. If you had to remove the interest of that investment to pay your bills and live your life in retirement—meaning the bank interest was removed instead of left to compound over the years—you actually lost money!
Now, if we look at the same $1 invested in Large Company Stock over the same 90 year period, your $1 will grow to approximately $9,200. Even if you removed the dividends over the years, your dollar still grows to around $253. Source: Ibbotson SBBI 2019 Classic Yearbook © Duff & Phelps
Managing Inflation by Growing your Portfolio:
Relative to short-term market risk, cash and bonds are safe and have a place in your portfolio. But relative to maintaining your purchasing power (the ability to buy the goods and services that get more and more expensive throughout the decades of retirement) having your money in cash and bonds isn’t safe at all. In fact, it’s downright risky.
If you keep your money only in “safe” investments, you are unknowingly setting yourself up for an income that will become increasingly difficult, if not impossible, to keep up with inflation.
Ah yes, we mentioned today’s buzz word, Inflation. Inflation, as we are all experiencing right now, is the costs of goods and services rising. The only thing that a retiree should be concerned about regarding their portfolio is how to grow it. Because if this year teaches us anything, is that we don’t know where prices will be in the future—but we know they will, over time, increase. Inflation has averaged around 3% per year since 1926. As we’ve been in a relatively low inflationary environment for decades, folks forget to factor it into their planning. But in a possible 30+ year retirement, you must factor in rising costs and have a plan to double and almost triple your income. And yes, we understand that as you get older you will most likely spend less money on travel and activities than you do in the first few decades of retirement. However, have you considered that when lifestyle costs decline, medical costs often are rising? And healthcare costs rise significantly more than the average inflation rate! Now, what does 90 years of market history tell us is the only thing that will help your portfolio keep pace with inflation over your retirement decades? Stock.
Stocks are a form of ownership; they represent participation in a company’s growth or decline. Ownership allows you to participate in the appreciation of a company, where cash (and Bonds, as a debt obligation) do not. If a retiree can accept the short-term volatility that accompanies stock, they’re much more likely to protect their purchasing power throughout the decades.
So, what’s the safer place for retirees to keep their money: cash or stocks?
In a few words, for money needed in the short-term, cash and bonds; for long-term investors (which as a retiree, you need to be a long-term investor), a thoughtful percentage in stocks.
We recognize that when the media is screaming Armageddon it’s hard to filter out the noise to see the opportunities. It’s important to recognize that the psychology of risk avoidance will likely lead you to make decisions with your money that could hamper your ability to maintain your lifestyle. You will need to accept certain levels of volatility in your portfolio in order to garner the returns that will both keep pace with inflation while also allowing your income to grow.