In high school physics class, I learned that energy cannot be created nor destroyed, it can only be transformed. Within investments, the same principle applies to risk. To start, risk is a tricky thing to define. The financial world has settled on a measure of volatility called standard deviation. Although imperfect for a variety of reasons, standard deviation gives a quantifiable measure of how bumpy the ride has been which is a reasonable approximation for how it will be moving forward. Unfortunately, volatility is usually equated with losses. What about the opportunity cost of missed gains?
As a society, we have been conditioned to think that financial risk is checking our monthly statement and seeing a lower number than the month before. That type of downside risk is intuitive and easy to understand – money, which was once yours, no longer appears to be so. Upside risk is much more abstract in an alternate universe type of mental exercise – we have no way of accurately quantifying what might have been. Our desire to hold onto what is already ours will sometimes cause us to make short-term decisions with long-term money because the pain of losing money is greater than the satisfaction of making money.
In finance textbooks, the risk-free rate of return is typically the return on a government issued bond. This is somewhat of a misnomer for an individual investor with a “cash under the mattress” mentality. Inflation is a silent killer of financial plans for those who “don’t want any risk.” Unaccounted for, it gradually eats away at the spending power of your money which technically leaves you with less money than you had before. Mentally, it is the easiest risk to cope with because we trick ourselves into saying that we still have the same amount of nominal dollars as we did before. Inflation risk doesn’t even compare to the upside risk we spoke about before. I have talked to plenty of people who have been sitting in cash for years just waiting for things to calm down to get back into the market. This type of second-guessing is a paralyzing fear. Afraid to make a misstep, investors instead do nothing and jeopardize their growth potential. Like inflation, upside risk is invisible, but potentially catastrophic for a financial plan. To tie this back to physics class, moving money into cash is not de-risking the portfolio, it is merely a transformation of the risks that one is bearing.
In the short-term, cash is the safest investment and stocks are one of the riskiest. As one zooms out, those roles become reversed. The problem for many is that when downside risk rears its head, focus shifts to the short-term. “It’s just for now. I’ll re-invest when things calm down,” we tell ourselves. The coast is never completely clear, and the invisible losses incurred by sitting in cash for too long have a negative compounding effect on future plans. Investors are always searching for the optimal portfolio or investment strategy. The solution is clear: whichever strategy you can stick with. As always, it helps to have an objective voice on your side to help see the big picture.
Author: David Rath, CFA
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