We see it often: Whenever investors are spooked by turbulent times, dollars tend to flow out of the stock market and into “safe harbor” investments such as bonds, bond funds, CDs, money markets, or even cash. As part of your overall investment strategy, it usually makes sense to allocate some of your wealth to safe harbor holdings. But too much “safety” can actually put your wealth at risk.
The ups and downs of volatility risk
Even during calm times, we tend to think of fixed income or bonds as “safer,” and equities or stocks as “riskier.” These labels are relatively accurate if we’re talking about volatility. That is, as an investment grows over time, how wildly will its price swing up and down along the way?
Fixed income is less volatile
A high-quality bond or similar holding priced at $100 today will probably be priced around the same a year from now, give or take a few dollars.
Equity is more volatile
In contrast, it’s anybody’s guess what an individual stock might be trading for a year from now. You might catch a wave and see your investment surge. But your holding could also be worth considerably less, or even become worthless.
As such, it’s usually wise to protect against volatility risk for the assets you’ll need for the next 1–5 years or so. But make no mistake about it, when you seek a safe harbor you are not only protecting your assets from losing a lot of value, you’re also effectively eliminating the chance they will gain much.
In other words, volatility contains both upside opportunities and downside risks. As such, a safe harbor is only partially safe – because volatility risk is not the only risk around. In fact, we would argue that long-term investors face an even greater risk: inflation.
“But too much ‘safety’ can actually put your wealth at risk.”
Again, it’s important to prepare for upcoming spending goals by protecting against volatility. What if you’ve got college costs, or a home purchase, or similar expenses looming? If a bear market happens to roar in at just the wrong time, you don’t want downward volatility to eat into the assets you’re depending on for these near-term needs.
On the other hand, volatility risk is far less of a concern for distant spending plans. It’s largely expected to fade when viewed across longer timeframes. Alan Abelson provides a helpful analogy for comparing the stock market’s expected long-term growth versus its near-term volatility: “It’s like a man walking up a big hill with a yo-yo and keeping his eyes fixed on the yo-yo instead of the hill.”
Author Daniel Crosby provides a more empirical illustration: “Greg Davies shows that if you check your [stock] account daily, you’ll experience a loss just over 41% of the time. … Look once every five years and you would have only experienced a loss about 12% of the time and those peeking every 12 years would never have seen a loss.”
If you have the time (and emotional stamina) to tolerate the market’s volatility risks, you can expect to benefit from its uphill climb. In contrast, reacting to a volatile “yo-yo” is only expected to distract you from your financial journey. This is important, because market growth is essential to combatting the other risk we’ve mentioned: the insidious impact of inflation.
Inflation is forever
Why do we save and invest? You SAVE money you don’t need today for future spending. You INVEST some of your savings to strengthen your reserves. Typically, the goal is to maintain, if not improve on, your lifestyle.
Why not just sit in cash or its equivalent? After all, if you stash $100 in a sturdy lock box, it’s highly likely to stay there. Even decades from now, it should still have a $100 face value.
But there is a catch. Inflation virtually guarantees that this same $100 will not buy you as much in the future. For example, a $100 purchase made 20 years ago would now set you back about $153.
A degree of inflation is actually built into a healthy economy. For example, the U.S. Federal Reserve targets an annual inflation rate of around 2% to achieve price stability. That is why it is usually wise to invest savings you won’t need for a while in stocks, and keep them invested. The more you allocate to “safe” investments, the more likely inflation will diminish your spending power. The more you allocate to low-cost, globally diversified stock funds, the more effectively you can combat inflation risk, if you ignore the yo-yo throughout the journey.
A good advisor will help you to determine the right balance between safe-harbor holdings versus sources of higher expected return. And, perhaps more important, that same advisor will minimize your temptation to watch the yo-yo when you should be focusing on the hill.