Avoiding Risk Will Cost You
Why Maintaining Wealth Requires Risk
“What’s your number?”
Recently, while partaking in some mild social distancing, a friend asked me this seemingly innocuous question. He further elaborated, “What’s the number you need to hit to live off the interest?” In the economic uncertainty of life with Covid-19, this friend had retreated to the financially conservative tenants of the FIRE movement, that is, “financial independence, retire early.” His logic was that removing risk increased certainty, allowing him to save his way to early retirement.
His overabundance of caution is actually doing more harm than good.
Excessively Conservative with Money
No financial vehicle is truly riskless. Theoretical finance assumes treasury bills are “risk-free” because they are backed by the full faith and credit of the United States government. For the average person, an FDIC insured bank account is similarly riskless, as the government protects your deposit in the case that the bank fails. No risk, no return. Implementing an all-cash strategy in the last decade would have yielded a negative real return, as purchasing power is eroded by inflation.
For a brief period, high yield savings accounts (HYSAs) provided a suitable alternative for the fiscally conservative. When introduced to the market, products like Marcus and Varo offered both FDIC insurance and interest rates that preserved wealth. When the Federal Reserve (Fed) lowered rates in response to the economic threats of Covid-19, these products were no longer able to uphold the name “high yield.” Today, rates range between 0.40–0.70% APY, making them only slightly more useful at preserving wealth than a checking account.
The Risk Curve
If we continue comparing the risk and return of various financial vehicles, it becomes easy to construct a risk curve, otherwise known as the Efficient Frontier. This line represents the maximum expected yield for any level of risk that we assume. Any point above this line is unattainable and any point below this line is inefficient, as higher yield alternatives exist at that level of risk. The inflation rate can be viewed as a hurdle rate or minimum acceptable rate of return.
The risk curve is not static, but shifts due to changes in economic conditions, being especially susceptible to changes in the Fed Funds Rate. When the Fed lowered interest rates to 0% in 2008, they indirectly changed the risk/return relationship for all asset classes. Speculative investors moved further down the risk curve in search of yield, often taking advantage of low rates to borrow and leverage their exposure. Evidence of this is the unprecedented growth of the stock market as well as new asset classes, like cryptocurrencies.
The percentage of Americans with exposure to stocks and bonds has declined significantly over the past 20 years. Many don’t have the resources to make informed decisions in the market, causing them to perceive greater risks. For these investors and savers, there is a wide gap in the yield curve between too much risk and not beating the hurdle rate. As a result, the safe decision is the conservative approach.
Diversify Your Risk Exposure
Everyone’s situation is unique and low-yield investment vehicles still serve a purpose. A checking account doesn’t need to chase yield because the expectation is the cash will be spent before inflation affects your purchasing power. It would be similarly ill-advised to assume too much risk in an emergency fund. Be wary of any product that offers a debit card plus high returns. You may be assuming more risk than you can afford.
Risk can be a powerful tool to enhance future outcomes. Medium and higher risk strategies are generally better suited for long term savings and investments. These potential returns will help to build wealth while allowing suitable time to catch up in the event of an unexpected loss. A good rule of thumb is not to invest more than you can afford to lose today.
A relatively conservative portfolio that exceeds the hurdle rate can be constructed by combining various levels of risk with multiple investment types. Unless you are a seasoned investor, you may not know where to look to achieve your desired level of risk. So, what’s your number? How much risk exposure will you require to meet your goals? If you only value safety, you’re losing value.
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