February 25, 2013 – Published in the North Bay Business Journal
Many aspects of life require careful consideration and balancing of the tradeoffs that arise from competing demands. For example, a common lifestyle tradeoff is working longer hours versus spending more time with your family.
The competing demands within this decision are the income necessary to provide a suitable quality of life for your family versus the immeasurable benefits of quality time spent with them. There is no right answer, but most people understand the tradeoff and attempt to find the balance that is right for them.
Successful investing and financial planning also require a balancing act. For instance, a common investment tradeoff is that of risk and return. One of the competing demands is preservation of capital versus preservation of purchasing power. The former may allow for a better night’s sleep during periods of heightened uncertainty and corresponding volatility, but the latter helps ensure you’ll have a comfortable lifestyle in the future when accounting for rising prices from inflation.
Once again, there is no right answer, but understanding the tradeoffs between preserving capital and preserving purchasing power will help investors find the balance that is right for them. This balance will depend on their definition of risk and attitude towards it.
To most, risk means volatility. They have difficulty stomaching the daily ups and downs associated with investing in asset classes that experience significant price fluctuations, such as stocks, because declining prices are often accompanied by predominantly negative headlines. Although such information will be reflected in prices before anyone can react to it, this is little solace to those who project the recent past into the future and see bad news as an indicator of what’s to come rather than a commentary on what has already happened. These investors yearn for short-term preservation of capital.
Others may define risk as a diminishing standard of living. They have long-term financial obligations, such as spending during their retirement years, and their primary goal is to build wealth to meet those future expenses. They recognize that while the cumulative effects of inflation are sometimes glacially slow or even undetectable in real time, they can be the silent killer of a financial plan. These investors desire long-term preservation of purchasing power.
Investing is relatively straightforward when the definition of risk and attitude toward it are so black and white. For example, you can virtually guarantee the preservation of capital by investing in the equivalent of Treasury bills as long as you accept the corresponding potential for the loss of purchasing power. On the other hand, you can preserve purchasing power by investing in asset classes with expected returns exceeding inflation, providing you accept price fluctuations that can temporarily impair your capital.
Unfortunately, in practice, investing isn’t that simple. Individuals rarely have black-and-white objectives or well-defined definitions and attitudes towards risk. Some expect long-term preservation of purchasing power and short-term preservation of capital. Making matters worse is the tendency for the priority and relative importance of people’s competing demands to change over time, often in response to what’s happened in the recent past.
Those who succumb to the “cycle of fear and greed” end up chasing a moving target. Investors should instead take a longer view of the tradeoffs they made when considering assets that may be expected to outpace inflation and those that stabilize the portfolio and reduce its fluctuations. When investors become more focused on capital preservation as a result of short term bad news, it’s a good time to revisit the reasons growth assets (i.e. stocks) were in the portfolio from the outset, and how the so-called “riskless” asset” (i.e. Treasury bills) can actually be extremely risky in the long run without portfolio diversification.
More than ever, comparisons like these are needed when discussing the tradeoff of preserving capital versus preserving purchasing power. Investors feel the risk of stocks in real time. Volatility is immediate as portfolio values show up in the mail every month or on the computer screen every day. Conversely, the risk of investing in CDs and other low-volatility assets is less discernible and may take time to detect because it shows up when investors open their wallet at the grocery store or gas station many years later.
Investors should continually revisit the tradeoffs they accepted early in the investment planning process, and alter course if appropriate. However, changes to a long-term plan should reflect informed and judicious decisions rather than emotional ones. Fear and greed are powerful forces, but we should resist letting them dictate the tradeoffs we make in our lives or in our portfolios.