Most people feel the pain of losing to a much greater magnitude than the pleasure of winning. In fact, psychologists find that losses are twice as powerful as gains on an investor’s psyche. They call it “loss aversion.”
In this month’s cover article, What Risk Is — And Isn't, investment pro Howard Marks describes dealing with risk as “the essential element in investing” and notes that “most level-headed people want to avoid or minimize” risk. The greater an investor’s desire to avoid loss, the greater will be his or her desire to avoid risk.
Minimizing risk, of course, is the driver behind many money management fundamentals. For example, the idea that everyone should maintain a reserve of money in an ultra-safe savings account is to minimize the risk of a financial emergency, such as a job loss or an unexpected major expense.
When it comes to investing, diversifying one’s holdings rather than putting all of your eggs in a single basket helps minimize the risk of being overly concentrated. This type of advice is appropriate and helpful.
However, sometimes the riskiest thing you can do financially is to play it too safe. Here are a couple of examples.
Letting compounding slip away.
Young people are often stereotyped as inherently bold risk-takers. When it comes to investing, that image appeared to prove true during the COVID-19 pandemic, when 20-somethings got a lot of media attention for chasing meme stocks and following the social-media influencers who live-streamed their day trading.However, research about the broad Gen Z cohort (adults ages 27 or younger) paints a different picture. A recent nationally representative study conducted by WalletHub found that Gen Zers are the least financially confident generation and 57% of them think savings accounts are the best way to invest their money.
Even the group one notch older, Millennials (ages 28 to 43), appear to be surprisingly risk-averse. A 2023 study by Schwab Asset Management found that Millennials are especially interested in an asset class more commonly associated with older investors: fixed income. Compared to the cohorts of Gen Xers (ages 44 to 59) and Boomers (ages 60 to 78), Millennials rate higher for wanting to learn more about fixed-income investments, planning to invest in fixed-income funds over the next year, and currently having money invested in bonds or other fixed-income investments.
Failing to recognize the impact of future inflation.
I recently spoke with a 65-year-old new retiree who has all her retirement savings in cash. She said she could live just fine on Social Security and the $450 she was taking out of her retirement savings each month. When I asked how long her savings would last if she kept taking out $450 each month, she knew the answer immediately — a little more than 25 years.She had run the numbers and thought she was in good shape. But she isn’t because she isn’t factoring the rising cost of living into the equation. Because of inflation’s corrosive power, $450 will buy far less in the future than it does today. That means her standard of living will decline steadily as the years pass.
This investor doesn’t want to take any risk. Yet, by playing it so safe, she isn’t just risking the possibility of financial trouble down the road, she’s all but guaranteeing it.
To better prepare for the future, investors nearly always need to accept some degree of risk. In this case, even the extremely conservative step of buying an annuity with an inflation rider involves some risks. An annuity would likely provide her with a higher monthly income while also locking in some inflation protection. However, her cost of living could still rise faster than inflation, and if she were to die soon, it would leave her heirs with less due to the cost of the annuity.
Alternatively, SMI might suggest that she invest her savings, using a 50/50 blend of Fund Upgrading and Dynamic Asset Allocation. A conservative allocation could have 20% of her Upgrading portion invested in stocks and 80% in bonds. Further, both strategies have downside protection built in.
Either way, the risks of action must be weighed against the risks of inaction.
Investment risk certainly should be managed, and to whatever degree possible, minimized. No one gets bonus points for taking more risk than they need to. However, sometimes the riskiest thing you can do is
to play it too safe.
