With so many threats to our financial well-being, it’s hard to stay on top of all of them! Stock market losses, unexpected events, taxation, disability, job loss to name a few. As difficult as it is to overcome the financial threats we can see, imagine how difficult it is to overcome the ones we can’t.
Too often we, as investors, become so concerned with market risk (the risk of losing capital) that we are driven to do nothing. And what I mean by nothing is also called “paralysis by analysis.”
Are you guilty of this? One sure-fire way to know is leaving too much money in a savings account. That’s right-too much money in savings.
I recently had a discussion with a family member that suggested they would rather leave their money in a savings account over investing because they didn’t want to lose any money.
What you need to understand (and my family member) is that what you can’t see can actually hurt you.
If you have money in a savings account, you are losing money!
How can this be you ask? There are more types of risk than just market risk (the risk of losing capital).
- Market Risk (losing capital)
- Tax Risk (increasing taxation devalues your investments)
- Political Risk (changes in politics cause a negative affect on investments)
- Liquidity Risk (the inability to access your money)
- Inflation Risk AKA The Silent Tax (the risk that inflation will reduce purchasing power of your money)
Now, I understand that there comes a time when preservation of capital is key. Keep in mind, however, that there is inherent risk in every decision we make. I want to talk about inflation risk today. Take for example the following illustration.
The blue portion of this chart represents $300,000 earning 1.09%* in a Savings Account, Certificate of Deposit, or Money Market Account. The real story is illustrated through the red portion of the chart representing the same account adjusted for inflation. We can see that the Risk of Inflation, often referred to as the ‘silent tax’ plays a major role in the destruction of wealth.
So, what can be done?
Historically, stocks have outperformed inflation by significant margins. Most investors tend to steer away from investing in the market during their retirement years from fear of Market Risk but never consider the destructive forces of Inflation Risk. The green portion of the previous chart represents a conservative portfolio (25% stocks/75% fixed income**) adjusted for inflation during the same time period. As you can see, the result is staggering.
Most prudent retirees would be better served utilizing a strategy that accounts for both Market Risk and Investment Risk. Whether your goal is to preserve, grow, or pass on your wealth, a balanced approach to saving and investing will provide sufficient money to spend during retirement and the opportunity to leave a larger legacy to your heirs.
*Source: Bankrate’s 2012 average Certificate of Deposit rate of return
**Matson Money’s DFA funds Conservative Portfolio