The Risky Flight to Safety

Imagine this.

Your broker calls and offers you a portfolio "guaranteed" to reduce your purchasing power every year.

Any takers?

Of course not. Yet that's what investors do when they "flee to safety" by dumping stocks and investing solely in CDs, Treasury Bills and other "risk free" investments.

Some of the most respected fund families have seen huge net outflows. These include stock funds managed by American Funds, Legg Mason, Vanguard and Fidelity.

Where are these investors putting their money? Mainly in Treasury Bills, causing those interest rates to plummet. The investment rate for a 52 week Treasury Bill issued November 20, 2008 was 1.063%.

Does this make sense for the vast majority of investors saving for retirement?

No.

Let's take a 45 year old investor who expects to retire at 65. This investor has $100,000 in savings. How much will she need to have the same buying power at age 65?

I don't have a crystal ball, but I can compute the answer for the past 20 years, starting in 1988: $183,071, based upon the average Consumer Price Index for each year.

An interest rate of 1.063% for 20 years will increase her portfolio to only $123,476--a shortfall of a whopping $59,595.

Interest rates could increase over the next 20 years which would have a positive impact on returns. However, if they did, it is likely that inflation would also increase, resulting in a reduction of purchasing power even though returns would increase.

Historical data is not predictive. Recent market events make that painfully obvious. With that caveat in mind, what if this investor studied the long term historical data and decided to assume as much risk as she could take? She would invest 100% of her portfolio in a globally diversified portfolio of stocks, recognizing that she would not need access to this money for 20 years.

Her $100,000 investment in 1988 was worth $673,493.20 as of October 31, 2008.

What if this investor thinks "it really is different this time"? She wants a much more conservative portfolio. She decides to invest only $15,000 in stocks and the balance in bonds, using passively managed stock and bond funds.

Even with this extremely conservative portfolio, over the same time period, her original $100,000 investment would be worth $324,179.

There is no way to keep pace with inflation and taxes over the long term by investing in risk free Treasury Bills or FDIC insured Certificates of Deposit.

Investors who have less than a five year time horizon should have little or no stock market risk. However, if you don't need access to your money for a longer period of time, your investments should consist of an appropriate balance of stock and bond index funds, ETFs or passively managed funds.

Risk, like beauty, is in the eye of the beholder. A "risk free" portfolio can be the riskiest investment you will ever make.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein.

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Comments

[jan4insight]

Except for a small amount I keep in a socially-r­esponsible mutual fund, I bailed out of the stock market some years ago, after the crash of 2001. Today - I am soooo glad that I did.

[AmericanFool]

I think it was ok to bail, as I did, incrementally, checking assumptions along the way. I'm down 13-14% this year, but would have been down 40% or so, as I'm normally an aggressive investor. I don't need to know when to buy back in, because I'm DCAing my way at 5% per month. I agree that the stock market is generally not predictable, but I do believe that sometimes, rarely, it is. I think Mr Solis is right advising most people to buy and hold, but I think there are opportunities to beat buy and hold if you know something others don't know or don't acknowledge. The asset bubble was known, but not priced into the market, because the flip side of the equation, asset devaluation, hadn't been experienced in decades. The real problem is, where can you find protection for any portion of your capital? Asset (de)valuation and currency swings make even treasuries and CDs suspect for those in pursuit of capital preservation. I think equities are fairly valued now, and though I believe they may drop 25% next year as earnings are announced, I began to DCA back into a balanced portfolio as of this Nov.

[Brian123]

Risk or no risk, what is needed more than anything else to reassure Americans and help get the economy moving again is an uptrend and reduction in volatility in the equity markets. To turn the stock market around and get investors back in the game, Larry Summers should announce that Obama will declare a one year tax holiday on any capital gains earned on long-term investments made in public US equities during 2009. Doing so will cost Treasury nothing up front, unlike every other move they are currently making and will give investors too good a deal to pass up. It must only benefit long term investments, however (a year or more?) to force hedge funds and other institutional investors to think longer term and reduce both speculation and consequent volatility. If the equity markets start to rise again, private capital will be able to replace public capital in stabilizing troubled entities, and we can begin the re-equitizing of American financial and industrial companies.

[GordonDR]

Mr. Solin: I don't dispute your overall argument, but your example is hardly fair:

"I don't have a crystal ball, but I can compute the answer for the past 20 years, starting in 1988: $183,071, based upon the average Consumer Price Index for each year. An interest rate of 1.063% for 20 years will increase her portfolio to only $123,476--a shortfall of a whopping $59,595."

If you are going to look at the CPI increase from 1988 to 2008, then why don't you look at actual T-bill yields over the same period, instead of at the very low rate that prevails right now? Why offer only this _conjecture?_--

"Interest rates could increase over the next 20 years which would have a positive impact on returns. However, if they did, it is likely that inflation would also increase, resulting in a reduction of purchasing power even though returns would increase."

Come on--tell us how your hypothetical investor would have done if she had put her $100,000 into laddered CDs, mainly with 5-year terms. And what if she had put $90,000 into CDs and $10,000 into an index fund? Surely that would have let her sleep at night. People who are selling equities and putting the money into risk-free instruments, though they are probably foolish to sell low, aren't necessarily doing that with 100% of their assets.

[cylindar]

Haha There is no such thing as a risk free portfolio anymore. It is definitely a salad toss. What is really amusing is that people have been led to believe that the government can afford to bail them out. Print more money and don't look back. You are right about long term investment strategy but even that scenario is looking cloudy as to the form of the shakeout. It certainly will be intereresting to see what happens.