Risk is an inherent part of investing and goes hand-in-hand with return. Most investors need to take a certain degree of investment risk, and if they do not, they may be limiting their possibility of return. Theoretically, the greater the risk an investor takes, the greater the returns he or she demands for taking such a risk. However, this is not always true and not all types of risk are compensated by the potential for additional return. This is because risk is a relative term and there are several forms affecting different asset classes: purchasing power risk, reinvestment rate risk, market risk, and exchange rate risk to name a few. Additionally, risk differs depending on perspective and time horizon. For example, someone with liquidity and cash flow needs faces different risks than someone who does not need the money for thirty years.
Historically, stocks have been the only asset class that has reduced purchasing power risk; the effect of inflation on one’s portfolio. On the other hand, stocks can be very volatile in the short-term and these fluctuations are unpredictable.
Enter the Paradox of Risk
How does one balance the short-term risk of investing in stocks with the long-term risk of not?
The short-term risk is volatility. The long-term risk is loss of purchasing power. To decrease the short-term risk it is helpful to avoid stocks, traditionally a volatile investment over short time periods. To decrease the long-term risk it is helpful to be in stocks, traditionally the only asset class that keeps up with inflation.
There are certain scenarios where this becomes especially tricky. For example, it is common practice to use 100 as a planning age, the estimated age of death, to ensure one does not run out of money. Where does this leave a 75 year old? He or she likely has liquidity and cash flow needs; however, their time horizon is now 25 years so inflation comes into play. To make matters more complicated, their parents likely went through the great depression and raised them to be wary of investing, or at the very least err on the side of caution. Combine this with the insecurity that comes with a lack of salary, assuming they are retired at this point, and one truly faces a challenge.
How much of this investor’s portfolio should be in stocks, keeping in mind the paradox of risk?
While “it depends” is never a satisfying answer, I would venture that is what should be said here. A healthy amount of stocks, in the form of diversified low-cost mutual funds, could be appropriate, but if the volatility keeps the person up at night, compromises might have to be made. Furthermore, inflation is not something easily projected. A low inflation or even deflationary environment would drastically alter the approach towards purchasing power risk.
Financial planning is all about trade-offs: sacrificing something in order to gain something else. Typically, these trade-offs are across time in the form of delayed gratification. That is, giving up something today for something in the future. An investor often must stomach the day-to-day fluctuations of the stock market for the potential long-term returns. Point being, the paradox of risk is an important trade-off an advisor must consider when making allocation decisions for a client: while investing in stocks results in risk in the form of volatility in the short-term, not investing in stocks results in risk in the form of loss of purchasing power in the long-term.
An advisor must understand a client’s risk tolerance and risk capacity in order to address the trade-offs that results from the paradox of risk. In addition, managing expectations, specifically avoiding getting caught up in the day-to-day fluctuations, is key. As Josh Brown says, “volatility is not the enemy of the long-term investor. That investor’s response to volatility is.” In summary, while the short-term volatility of investing in stocks and the long-term risk of inflation are two sides of the same coin, the paradox of risk trade-off decision depends on the individual investor.