Understanding Risk ...as Critical when Investing as when Flying (Part 2)

Updated: Jan 19

In our last blog, Understanding Risk ...as Critical when Investing as when Flying (Part 1), we looked at how choosing a portfolio that is too risky (volatile) can hurt returns and the odds of achieving your goals. In this blog, Part 2, we will look at how choosing a blog that doesn’t have enough risk may also reduce your odds of achieving your goals.

One of the main challenges when planning for retirement is planning for inflation. Figure 1 below shows an example of the loss of purchasing power. One could buy a quart of milk for 9 cents in 1916. By 1966 9 cents bought only a small glass of milk and by 2017 it bought only 7 tablespoons of milk.

Figure 1. Inflation causes a decline in purchasing power.

As the value of a dollar declines over time, investing can help grow wealth and preserve purchasing power. Investors should know that over the long haul stocks have historically outpaced inflation, but there have also been short-term stretches where this has not been the case. For example, during the 17-year period from 1966–1982, the return of the S&P 500 Index was 6.8% before inflation, but after adjusting for inflation it was 0%. Additionally, if we look at the period from 2000–2009, the so-called “lost decade,” the return of the S&P 500 Index dropped from –0.9% before inflation to –3.4% after inflation.

Despite some periods where stocks have failed to outpace inflation, one dollar invested in the S&P 500 Index in 1926, after accounting for inflation, would have grown to more than $500 of purchasing power at the end of 2017 and would have significantly outpaced inflation over the long run. The story for US Treasury bills (T-bills), however, is quite different. In many periods, T-bills were unable to keep pace with inflation, and an investor would have experienced an erosion of purchasing power. After adjusting for inflation, one dollar invested in T-bills in 1926 would have grown to only $1.51 at the end of 2017. Figure 2 below shows this concept graphically.

Figure 2

Figure 2. The Growth of $1 compared with Inflation.

Figure 3 below shows the growth of $1 invested in various indexes from a US Small Cap Index (on the high end) to US Treasure Bills (on the low end.). The point that is important to consider is that, while we never know what lies in the future, from 1926 - 2020, one should consider their risk tolerance carefully and invest according to that tolerance because it can affect predicted future values.

In summary, inflation is an important risk consideration for many long-term investors. By combining the right mix of growth and risk management assets, investors may be able to blunt the effects of inflation and grow their wealth over time. Remember, however, that inflation is only one consideration among many that investors must contend with when building a portfolio for the future. The right mix of assets for any investor will depend upon that investor’s unique goals and needs. A financial advisor can help investors weigh the impact of inflation and other important considerations when preparing and investing for the future.

So how do you determine your risk tolerance? There are many advanced software programs designed to help you. My favorite is a risk tolerance assessment tool is called Riskalyze. If you're interested in trying it out, here's a link to my video explanation and a questionnaire.

Disclaimer: Past performance is no guarantee of future results. Any indices referenced for comparison are unmanaged and cannot be invested into directly. Investments in securities involve the risk of loss. Nothing in this blog should be considered financial advice or recommendations. Your questions are unique to you and your own personal financial circumstances. You should consult with a financial professional before making a financial decision. See full blog disclaimer.

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