Hey everyone, I’m back with another financial planning Tip of the Week! The topic is investment risk versus investment & financial safety. The traditional notion of investment risk is the possibility of a decline in the nominal value of that investment. In other words, if I own shares in a mutual fund worth $10,000 today, it’s possible that I could look at my account tomorrow and it’s worth $5,000. The opposite is safety… that my $10,000 account does not change at all.
In this viewpoint of risk, stocks tend to have the highest potential to lose value in the short-term followed by bonds and then bank accounts… which don’t change at all. The key words here are nominal value. With nominal values, we are primarily worried about the number of dollars in our accounts… or euros, or yen, simoleons, credits, etc.
In the end, that number by itself is irrelevant. Instead, the question is how much can that currency buy me? What is its purchasing power? For example, let’s say that you budget $50 each week to refuel your car. Last week, that $50 bought you 20 gallons. This week, you go back to the gas station, and that $50 only purchases 16 gallons. The amount that came out of your bank account didn’t change at all, but its value in terms of purchasing power went down.
So when we expand the concept of risk to focus on changes in purchasing power, our perspective of risk changes. Most people watching this video will remember the 2007-2009 financial crisis where the S&P 500 fell over 50% from its October 2007 high to March 2009 low. Scary, Right?
Well, let’s again look at Treasury Bill returns as placeholders for a savings accounts… Treasury Bills being short term U.S. government debt. Savings accounts will often pay lower interest than treasury bills, by the way. Treasury bills are considered the safest location for your money in the entire global financial system. However, the worst 1-year return for treasury bills in terms of purchasing power was negative 42%.[i]This horrible return occurred during the Korean War when inflation rose to 21%.[ii]
In this example, the number of dollars in your savings account would stay the same, but their purchasing power declined by almost half in one year. So your $50 buys you only 11 gallons of gas now… your ultra-safe savings account was not safe at all, it merely offered the illusion of safety.
When we look at periods beyond one-year, especially 5, 10, 15, and 20 years, achieving returns that increase purchasing power favors using stocks over bonds, savings accounts, and CDs by a wide margin. In fact, safety and risk is actually the reverse of the standard perspective. For long-term financial goals… where the investment objective is to increase our purchasing power beyond the rate of inflation or to maintain our standard of living in the face of inflation…and risk is the chance of not achieving the goal, then a diversified portfolio of stocks is actually the safest option. Bonds, CDs, and savings accounts carry much higher risk.
So back to those short-term ups and downs that freak people out. Quick tip: want to know how to decrease day to day volatility or price changes in your investments? Don’t look at them. Seriously. Or only focus on the number of shares that you own rather than the second by second change in their dollar value.
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Remember, the topics discussed in this video are for informational purposes only and that past results do not guarantee future performance. If you would like to discuss your financial situation, please email me at Derek.Merkler@Parsonex.com.
Advisory services offered through Parsonex Advisory Services, Inc., 8310 S.Valley Hwy, Suite 110, Englewood, CO 80112. 303-662-8700.