My brothers and I were recently at a meeting to help my mother manage some of her finances. She sold her house and needed to put her money into something low risk. As with most people of her age and even a couple decades younger, she has a high aversion for risk.
She was on the right track, of course. At her age, she should go low-risk, as any financial advisor will tell you. The problem is that low risk also means low rewards, which is a risk in itself. Here is how risk and rewards work, at a very basic level.
You can invest in stocks, and they will fluctuate with the economy and with the individual company’s financial health (or its perceived financial health). There is potential for great gain, but also for substantial loss.
The bigger and more established the company, the less risk, but also the less chance of hitting a jackpot.
Start-ups have a high failure rate, but if you invest in one that succeeds, you can sometimes earn 100 percent profit in just a couple years.
Bonds offer guaranteed rates. Although there is some fluctuation in the price of bonds when they are traded early, often inverse to the rise and decline of the stock market, the peaks and valleys are gentle. And they can always be redeemed at the guaranteed rate of interest at maturity. No risk. Some gain.
So the more you risk, the more you stand to gain. The less you risk, the less you stand to gain.
So low risk means no stocks, right?
Deciding the mix of your portfolio is a classic battle of greed versus fear. It’s the challenge everybody faces when handling their wealth management. Young people tend to be more greedy; old people tend to be more fearful. This makes sense.
When you are young, you can afford to risk a lot. After all, you’ll have time to make it up. Most importantly, if your portfolio takes a huge dip, you should not need to withdraw it at a loss. You can keep it in for the long term. And over the long term, the stock market always recovers and soars to previously unchartered levels of wealth.
In 2008, we suffered the worst recession since the great depression. By early 2011, stock prices had recovered and were already back into the profit zone. If you sold stocks during the downturn, you locked in a loss. If you hung onto them, you kept profiting. Not all stocks are created equal, of course, and I will get to that in a moment.
When you are old, you cannot afford to take as much risk. You will not have as long to make up for the loss, and living on a fixed income you might not have the means to do so. In fact, you might be gambling away your life savings if you have to withdraw your money before a recovery arrives. And ill health might force you to withdraw your investments with no advance warning, just at the time they are dipping.
My mother wanted low risk because she knows that at some point she will need a nursing home. Her current income pays for her current lifestyle, but the cost of a nursing home is higher and she will need those funds to be available so that she will be able to afford it. But she doesn’t know when, and she won’t know until the last minute, so she cannot afford to take the chance that a stock market dip will happen just when she needs to withdraw funds.
Or can she?
We met with a financial advisor at her bank, and he recommended a portfolio that was two-thirds bonds and one-third stocks. It had performed at about six percent annually over the long term. So after fees, my mom would make about four percent. With the current rate of inflation, she would make about two percent per year above inflation. That sure beats keeping it in the bank and losing each year to inflation!
But I noticed that there was another option, a portfolio with 55 percent stock and 45 percent bonds that had been averaging eight percent over the long term. The advisor we were meeting seemed a little uneasy about this, because that asset mix is not considered “low risk”; it has slightly more stocks than bonds.
What he was not factoring in when calculating risk, was the type of stocks included, which were over 80 percent large caps – the ones that weather financial storms and come out stronger on the other side. This is where it is important to distinguish between these so-called “blue chip” stocks and much-riskier start-up stocks. The big household-name companies are actually low risk investments, as long as you diversify; any one company could be a huge risk, but the large cap index is not.
The only issue is that if there is a slump, they might dip for a few years. If that is the case, they could bring down the portfolio into a loss situation, although not likely very far and not for very long.
But for someone of my mom’s age, that could be catastrophic, right? Suppose the stock market tanks right at the very time when she needs to withdraw the money. She would lock in a loss.
Or would she?
Not really, and here are the two reasons why she would not.
Why large cap stocks would not be “high risk”
First, we would be setting up two investment accounts, for tax purposes. So one could be higher risk and one lower risk. That way, even if she has to suddenly withdraw funds unexpectedly, she could withdraw only from the low risk portfolio that would not dip as much during a financial crisis.
Second, she would not be emptying it all at once. These investments are meant to see her through many years. Even if she did suddenly have to start withdrawing funds during a dip, it would be just a few thousand at a time. Even if we suffered a recession as bad as in 2008, much of her savings would still be in the second portfolio, in the black and rising, by the time she would have to withdraw them.
Furthermore, even the highest risk fund we saw was over 80 percent bonds and large cap stocks. No hedge funds. No start-ups. No Forex. No real-state based securities. The highest risk elements were mid-cap companies, under 10 percent of the portfolio, most of whom weather economic storms, but which are individually riskier than the large caps. There were no high-risk investments in the so-called “high risk” portfolio.
To summarize, even if a dip hit at the most unfortunate of times, my mom would have slowly withdrawn from the lower risk portfolio during the dip, and would not have had to touch the somewhat riskier portfolio (which is still pretty low risk) until afterwards.
So guess what I suggested?
Yup, I looked down the sheet and saw that there were other mixed portfolios, one with 65 percent stock (still 80 percent in low-risk large caps), which was making 11 percent over the long run, and some with even more stock and performing marginally better. I suggested that one of the accounts be placed in a low-risk portfolio and the other in a “high-risk” portfolio that was 35% bonds, 52% large caps and 13% mid-caps.
High risk? Yeah, right.
Although his face kept its composure, I could tell that the bank advisor’s insides virtually collapsed in a puddle of panic-induced entrails extract. Clean-up in aisle 7! He even pointed out that he might not be allowed to sign someone of advanced years up to such a “high risk” portfolio, even if they had plenty to get them through easily a decade on a “low risk” portfolio.
Reality check: The equities (stocks) in all their portfolios were 80 percent large caps. That means that those portfolios were high risk over a one-year span, a medium risk over a 2-3 year span, but pretty low risk over a five or greater year span. If my mother was covered with a low risk portfolio for the next five to ten years, why not grow her longer-term portfolio at a higher rate, so that it would last her longer?
Postscript: We ended up opting for one low-risk portfolio and one medium-low risk portfolio. I agreed to this, despite my logical common sense side saying that this is nuts. I agreed, for my mom’s comfort level, because she would have been very worried to see any dip at any time. We bought her comfort at the price of around $2000/year. Sigh.
Your turn: So, what would you have done?