This hard-charging stock market — up more than 23 percent for the first ten months of 2013 — has me regularly cautioning about the riskiness of what may be inflated prices. I think it’s an important message under the circumstances, but it’s hardly the last word about financial risk.
While the devastating impact of stocks falling from a great height is an obvious risk, there are other forms of financial risk which may be more subtle, but in the long run can be equally as damaging. The following are examples of financial risk which have nothing to do with a sudden drop in asset prices:
People who keep their money in savings accounts or Treasury bills are often referred to as conservative investors because their actions reflect a strong aversion to the risk of losing money. And yet, recent years have highlighted that too heavy a reliance on short-term, interest-bearing instruments can expose you to a very severe form of risk.
At the end of 1980, 1-year T-bills were yielding 14.88 percent, meaning they would pay $14,880 in interest annually on a $100,000 investment. Within just five years, though, that yield had been cut nearly in half, to 7.68 percent. This would reduce the annual income production of a $100,000 investment to $7,680, and the worst was yet to come.
Today, 1-year T-bills yield just 0.12 percent. That would produce a paltry $120 in annual income on a $100,000 investment. Now, suppose you had been investing in T-bills since 1980, living off the income and rolling over the principal. As a result, you would have seen your annual income cut from $14,880 to $120. You wouldn’t have lost a dime of principal, but I think you’d feel as though you’d definitely been exposed to a damaging form of risk. That’s interest-rate risk.
Anyone who lived through the 1970s and ’80s probably has some memories of what inflation risk is like, but recent decades may have made people more complacent. That’s just when inflation risk can strike.
Since 1989, inflation has grown at a compound annual rate of just 2.71 percent, so it hasn’t really been a problem. Similarly, from 1939 through 1969, inflation averaged just 3.29 percent a year, so it wasn’t a frequent concern. However, for 20 years immediately after that, from 1969 through 1989, inflation averaged 6.28 percent a year. In short, it can flare up when it seems to have been long dormant.
Those percentages may not adequately illustrate the difference these inflation rates can make, so consider this: At a 2.71 percent annual inflation rate, it will take about 26 years for the purchasing power of your money to be cut in half; a 6.28 percent inflation rate will cut your purchasing power in half in less than 12 years.
I’ve seen people take career risk in two forms. One is when someone’s career seems to be sailing along, and all of a sudden they get the carpet pulled out from under them. They lose a job, perhaps for reasons beyond their control such as a change in management or problems with their employer’s business. Suddenly, 20 or 30 years into a career, people in this situation find they can’t come close to replacing their former level of income.
The other form of career risk starts a bit earlier in a person’s career — usually to confident people who experience success early on. They take on expenses they can’t quite afford — a big mortgage, payments on a fancy car, etc. — on the assumption that continued success will bring them higher and higher levels of income as the years go on. Unfortunately, the economy just hasn’t been that generous in recent years, so these people find themselves trapped in an unsustainable lifestyle.
Everyone is at risk of career setbacks or disappointments, so never let your spending get ahead of your income. Also, keep your network of contacts and your job skills fresh. You never know when you might need them.
This could be the last risk you ever face — and it may seem counterintuitive until you experience it. This is the risk of living too long.
Retirement plans often fail to adequately prepare for today’s longer lifespans, let alone the fact that roughly half the population will exceed the average life expectancy. Plan to make your retirement spending as sustainable as possible, even beyond your expected lifespan, so you won’t be caught short.
Some people describe themselves as risktakers, and some as risk averse, but the truth is that we all take on some form of financial risk. We simply get some degree of choice regarding which risks to take. What you perceive as risk depends on your experience, and on your current situation. These perceptions can be instructive to others, so please share with us what you see as your greatest financial risk these days.