Many of us make trade-offs everyday . We attempt to balance one aspect of our life with another. This happens every day, all day. If we work more hours we will be able to provide more things for our family. On the other hand we have less time to spend with our family. To be happy we must balance the two. There is no right answer for everyone, just your answer.
While talking with investors we discuss their risk tolerance, how much risk are you willing to take? When I bring up the subject of risk, some look at me blankly, some instantly have the look of fear on their face and will begin to panic. I decided there must be a better way to determine the proper mix of assets for each investor.
Since the 2008-9 crisis and the subsequent volatility many investors have understandably moved capital preservation to the top of the list. The danger of this approach is that these same investors believe that capital preservation means no risk.
With capital preservation the risk these investors realize is the risk of inflation or loss of purchasing power.
This loss cannot be seen on their statements because their principal does not go down. However each year that passes this same principal will buy less goods and services. For example if you believe that $30,000 is enough annual income to meet your current needs. With just 4% inflation, which includes food and energy, in ten years you would need more than $44,000 to maintain your standard of living. In 15 years $54,000 and 20 years over $65,000.
Planning for retirement is very difficult because we have no idea how long we will live. What advances will there be in medicine? These questions go on and on.
Therefore I believe the question must become
- What balance of capital preservation vs. purchasing power are you comfortable with? In other words what mix of fixed income vs. equities will you be comfortable with while reaching your long term goals?
A younger investor might be comfortable with a higher proportion of equities, while someone nearing or in retirement might prefer one with a lower proportion of equities.
The former is interested in higher growth which exceeds inflation and the latter in more interested in less volatility while keeping up with inflation or maintaining their purchasing power.
Whenever you are deciding which balance is right for you ask these questions:
- What is the expected return?
- What is the expected volatility?
Whatever you decide there will be risks, some will be apparent some will be invisible. The invisible risk, inflation or loss of purchasing power, is the most dangerous to your financial future because it is unrelenting.
A globally diversified portfolio with the right balance for you will provide the best opportunity to reach your long term financial goals.
Remember equities are the greatest creators of wealth if properly used. This would involve that you
- Own equities
- Globally diversify
By following these rules you will reach your long term financial goals.