One of the most interesting words in the investing business is “risk.” It connotes danger, but also opportunity. And we misunderstand it at nearly every turn when saving for retirement.
Consider this old riddle from your elementary school science teacher. What weighs more, a pound of feathers or a pound of lead?
The unthinking student blurts out “lead!” while the more cautious kids stop to think. It has to be trick question, right? So they don’t answer at all.
Of course, a pound of feathers and a pound of lead weigh the same — one pound. That’s the joke.
We can extrapolate this to the investing world and find many active investors falling for the same tricky riddle regarding risk. Which is the riskier investment, $1,000 in the stock market or $1,000 in the bond market?
Both carry risk, and that risk can be equal easily enough. The answer you need requires more information.
Are you a long-term investor? Or a speculator trying to trade your way to riches?
Are you in need of cash today, tomorrow or next month? Can you reinvest dividends and interest payments?
Do you let your emotions take over when investments don’t perform to expectations? Do you ignore your investments until the news is truly, unbearably bad, then take action?
Can you sell an investment in a timely fashion and reinvest the cash in other investments that have declined in value? Can you in fact sell high and buy low, over and over, in a disciplined way?
All of these factors will drive the outcomes of a stock or a bond investment. A stock investment that is reinvested after it pays its dividend can, over the long-term, easily outpace bonds.
But that investment is likely to rise and fall in market value over the intervening years. It takes guts to buy more when it falls in value, and to sell off a portion when it is higher than its long-term average.
Bonds will be less volatile, but they are not risk-free. Interest rates have been rising steadily for decades, driving up bond prices. It has been remarkably easy to be a long-term bond holder.
That could change. A sharp change in the interest rate will make it harder to justify holding a long bond that pays less, perhaps even less than inflation. If enough people abandon that particular bond, its value will drop.
A portfolio approach allows retirement investors to own stocks, bonds, real estate and foreign equities and debt. Rebalancing forces the discipline of selling high and buying low.
It also depersonalizes the process, allowing you to feel less personally attached to any given position. Diversification not only reduces single-company risk, it reduces “attachment risk” that comes from owning a small number of companies for many years.
Most importantly, a diversified portfolio allows the long-term retirement investor to get the best possible result with the least amount of risk and stress — no riddles required.