By: Ryan P. Dolan
For long-term savers and investors there is a common misjudgment about what risk is, and what it is not. Many define risk as losing money. Ok, fair enough. And what is the prime financially risky suspect in people’s minds? Almost inevitably, it’s the stock market. I am always surprised at the questions people ask when they learn what I do: ”What do you think about the market?” or “What about this crazy stock market?”
This happened just recently. A friend, intelligent and successful, asked how I was weathering the recent stock market volatility, and whether I was getting calls from clients freaking out. I was initially confused-what volatility was he referring to? The market was within a few percentage points of its all-time-highs, and had been on an epic decade-long bull market. Admittedly, the market was churning up and down from one day to the next over the past few weeks, but this was not volatility in any real sense of the word.
And yet it hinted at a common fear. The subtext of these questions speaks to a widespread association that stocks are inherently risky. It’s understandable. Humans simply don’t like losing money. You worked years to save some money, you put it in the market, and 3 months from now it could be worth 15% more, 15% less, or the same-there’s no certainty. The market’s movements seem indecipherable, unpredictable, almost fickle. This drives people crazy.
Most questions typically boil down to asking for a prediction of the market’s near-term direction. This speaks to why most individuals, left to their own devices, tend to achieve lackluster investment results. Most view stock markets through the lens of short-term performance. And when looked at that way, the market’s actions do seem mercurial. I have no idea-literally none-of what the market will do over the next year. I also have no idea whether the next move is up 20% or down 20%. It took me a long time to learn this valuable lesson, by the way, and I have the investment battle scars to prove it.
The simple fact is, the longer the time horizon of the goal you are saving and investing towards, the less risk stocks pose, and the more exposure to them should be considered. Your job, with the help of your advisor, is to not only tolerate stock market volatility, but to learn to embrace it. The proper mindset views large price drops as a gift, as they lower risk and increase future return projections and allow future savings to be invested at higher rates. Volatility is only a loss if you need to sell-or worse, are emotionally compelled to sell.
So,
Point One: People consistently overstate the risks of long-term stock ownership, and mistake volatility for actual loss.
Which lead me to,
Point Two: This distorted view of risk paradoxically opens people to a genuinely real risk: the erosion of their long-term purchasing power, thereby jeopardizing their goals and financial security.
In my view, there are two main causes: one external, the other internal. First, the external. We live in an inflationary world. Everything we need to live our day-to-day lives, both tomorrow and three decades from now, will cost more than it costs today. We know this intuitively. A gallon of gas cost $0.96 30 years ago, and is $2.87 (over $4.00 in the Bay Area) today, an increase of 200%. A pound of bacon is up 175% over the same time period.
Inflation, and its relentless assault on your money’s purchasing power, can devastate improper long-term planning. A couple retiring today at 60, could conceivably have a 25 year, 2-person retirement-or longer. Over that time, they will see their expenses more than double! How will they prepare for that? Will their assets grow at a rate which ensures their lifestyle and independence over that long a time period?
In addition to overall inflation, I see another threat to purchasing power: the impact of lifestyle creep. With our core clientele, affluent professionals and business owners in their 30s to 50s, this seems to be a particular problem. Most of our clients are in the middle of successful careers, and have become conditioned to strong income growth. Typically, this has been accompanied by material increases in their lifestyle and expenses. What was considered a luxury or indulgence at 40 can quickly become a cast in stone necessity at 50. The problem is that income tends to be far more volatile than spending, and once spending patterns become ingrained, they are very difficult to reverse. In addition, we’ve found income growth for many starts to slow in their late 40s/early 50s, while lifestyle creep continues unabated. This is a worrying combination.
So what’s the solution? It is imperative to have a properly constructed strategy and battle plan. You need to define risk properly.
For long-term financial plans and portfolios, equity volatility and near-term market movements are close to irrelevant. Volatility does not equal risk. While stocks are not without risk, the longer your investment horizon, the less risk stocks pose. Widen out the lens through which you view stock performance. Stocks become an indispensable ally in the fight against purchasing power erosion. This combined with disciplined management of expenses and lifestyle creep form a double barrel approach to long-term financial success.