Sí, Money! – Vol. 2, No. 4 August 2008 – http://SiMoney.us
By Michael Grodsky

How does one determine risk and safety when it comes to financial planning for the future? George Harrison’s Savoy Truffle lyrics from the Beatles’ White Album tell us “what is sweet now turns so sour,” aptly describing the plight of Ron, a 70-year old Pasadena, California man with his life savings of $200,000 invested in only bank CDs ¹ because he thought it was safer than the stock market. ² While it’s true he is protected from the risk of fluctuating dollar account value (except to the extent his account exceeded FDIC insurance coverage ³), he is nonetheless exposed to the risk of losing the value of his money.

What exactly is money? Currency is the answer that pops into most people’s heads if they’re asked for a definition of money. Greenback dollars (contacthigh.net/grodzilla/greenback%20dollar.html) hidden under your mattress can come in handy during the aftermath of a big earthquake when grocery store registers could be offline.

When it comes to investing for the future, however, a better definition of money is purchasing power. In this context, the risk versus safety question Ron could have asked, “what investment plan design is most likely to ensure my future purchasing power?”

Another example: Rosa and Jack’s entire $600,000 retirement account is invested in Certificates of Deposit (CDs).  As of this writing, the average one-year CD rate is 3.57%. ⁴ Historically CD rates have tended to follow inflation as measured by the Consumer Price Index (CPI).  The chart below shows how CD rates moving with inflation during the 1970′s, a particularly volatile period. ⁵

Whenever prices start to rise, people often worry about inflation, and with good reason. The real return on an investment is not how many more dollars are in your account, but how much more you can buy with the money you have. So although Rosa’s and Jack’s CDs will not lose dollar value (setting aside for a moment the risk of bank default), historically they more or less merely keep even with inflation.

Utilizing a CD can be a logical choice when saving for a known short-term goal, such as a car purchase, or for use as a prudent reserve of six months to two years’ worth of income. But there is a surprising downside to this approach when only fixed income instruments are used for building long-term retirement goals. First, a bit about risk:

Risk comes in varied categories. Investments in the stock market have the risk of losing principal due to market ups and downs, also known as fluctuation or volatility. With stocks, the shorter the investment holding period, the greater the chance of loss.

Purchasing power risk (also called inflation risk) refers to the potential of an investment’s erosion in value due to inflation. People who rely upon fixed income investments such as bonds and CDs can be affected by this risk.  In addition to inflation risk, CDs may not provide the required growth over the long term in order to accumulate a nest egg goal, which is an example of the risk of running out of money before you run out of time.

When an artist no longer earns income and needs to live off of accumulated funds, the contribution phase ends and the distribution phase begins. If nest egg earnings offset inflation but nothing more, an accelerating downward spiral of principal depletion can result at such time the required withdrawal amount is greater than earnings. If the account value is sufficiently large, it may be some time before this occurs, if ever. But if principal is being withdrawn, in each successive period there will be fewer earnings. Yet withdrawals must increase to keep up with inflation. To keep up, each withdrawal will deplete an even bigger chunk of principal. And on it goes until the bottom.

If invested in a fixed CD earning 3.75%, Pasadena Ron could currently withdraw all of the about $7,500 in taxable interest from his $200,000 CD account without cutting into principal. ⁶ But in ten years he’ll need about $10,580 to buy what $7,500 pays for today, assuming annual inflation at 3.5%. If Ron depends upon that $7,500 today, where will the additional amount come from tomorrow? If he digs into principal, he will run out in about 25 years. If he needed $10,000 per year to start, his money runs out in 18 years. ⁷

In addition, 2009 will see medical cost inflation of nearly 10%, and it is older people on fixed incomes who are affected most. ⁸ Medical cost inflation is the projected increase in the costs of medical services assumed in setting premiums for health insurance plans.

This erosion of account value over time explains why relying only upon fixed income investments such as bonds ⁹ and CDs could be considered to have greater risk than the stock market. Again, let’s consider the two kinds of risk discussed above, inflation risk and fluctuation risk, in light of their suitability as long-term investments. Is there a strategy to tame market fluctuations and yet receive greater returns that more than offset inflation? That desire sounds like having your cake and eating it too, but consider what history tells us if our investment time horizon is long. There have been about seventy-four rolling ten-year periods between 1926 and 2008. The chart below shows that if you held an investment for ten years comparable to the stock market index shown, historically there was a 1% chance that a loss would occur. ¹⁰

The example below shows investment returns over a very long time frame, from 1801 to 2005. The chart shows the hypothetical result of $1 dollar invested in stocks, bonds, US Govt bills ¹¹ and gold. ¹²  All dividends are considered reinvested. “Nominal Return” means the effect of inflation is disregarded.

No one has 200 years in which to save for retirement, but the two charts above demonstrate that historical stock market returns over the long run are less affected by short-term volatility. And yes, your eyes are not fooling you–that’s about $11 million for stocks and $27 dollars for gold, in today’s dollars. The supposedly safe bonds and bills? They would have earned about $18,000 and $5,000.

The achievement of a written personal financial goal (and a plan for financial independence is not a plan without a written goal) depends upon three variables: how many years will you contribute, what amount will you contribute each year, and what is the rate of return of your investments? With these three we can estimate the potential future value of your nest egg, and plan accordingly. We can never predict the future rate of return, but the longer your holding period, the lower your chances of experiencing loss. Historically, it is apparent that utilizing only fixed income instruments for long-term investment goals can be riskier than equity investments such as a properly allocated portfolio of mutual funds.

I am not saying that bonds & CDs do not have an appropriate place in a retirement portfolio; What I am saying is that “safety” is not always what it appears to be, and that “risk” is not a singular definition that can be applied willy-nilly.

As in carpentry so does the truism hold for personal financial planning: choose the right tool for the right job. There is no such thing as one size fits all in life or investments. Financial products are simply tools. An individual’s or family’s plan, goals, and investment philosophy should drive the choice of specific investments within a well-designed, diversified portfolio. If you’ve got gazillions of dollars, then a mattress strategy might work for you. But most of us will need to address the conflict between living well today and taking care of our future self.

Michael Grodsky is an independent financial advisor for artists and collectors. He can be reached at 323-293-6800 or michael@aquariusfinancial.com
Registered Representative offering securities and investment advisory services through Independent Financial Group, LLC, a registered broker-dealer and investment advisor, member FINRA/SIPC. Aquarius Financial is not affiliated with IFG. This column is meant to provide general information, and should not be construed as providing investment, legal, or tax advice. Links are provided herein as a courtesy, and the referenced information is from sources we believe to be reliable; however, we cannot guarantee or represent that any are accurate or complete.

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Image Credits

George Harrison composite image
•    Crop from: President Ford with George Harrison and Billy Preston in the Oval Office. December 13, 1974. Photographer: David Hume Kennerly. Public Domain.
•    Stanley. Photo by Michael Grodsky. Used by permission of author.
•    Chocolate Truffles. God knows where this one is from.
•    Psychedelic_dingbats, 07/23/2007 Author: Hendrike 21:20, 23 July 2007. Permission is granted to copy, distribute and/or modify this document under the terms of the GNU Free Documentation license.

The White Album
•    This image is ineligible for copyright and therefore in the public domain, because it consists entirely of information that is common property and contains no original authorship.

Clock face
•    Title: Gravure01.jpg Author: Postelwijn 2006-10-21 Description: Voorbeeld van graveerwerk op een wijzerplaat van een lantaarnklok. Permission is granted to copy, distribute and/or modify this document under the terms of the GNU Free Documentation license.

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