What Does Risk Get You?

Source: Forbes

The relationship between risk and return in investment theory is fundamental.  To get a greater return, you need to take more risk.  This doesn't mean that taking more risk will get you greater return.  This is a subtle, but important, difference that is often confused.  For example, Tim Mauer in "Bad Advice for Younger Generations" writes, "It's a classic investing blunder to presume taking higher risks will naturally result in a higher rate of return."  He is exactly right - taking more risk is necessary to obtain a higher expected return, but it isn't a guarantee.  If financial advisors are saying it is a guarantee, which I don't think they are, they are wrong.

In fact,  the higher return could very well be gotten by the person who parks his or her money in CDs at 1.5% or, for that matter, buries money in the back yard.  We do know for a fact, however, that the latter two cases won't achieve a return of 8%.  To get the 8% annualized return, you need to take risk.

A casual observation of market history easily reveals all of this. It took decades to get back to the high point of stocks in the late 1920s. It obviously will be a long time before we see the peak reached by the NASDAQ in the dot.com bubble.

So how does the relationship between risk and return come up in the financial planning process?  Usually, after some serious number crunching, the typical planner arrives at a desired size of the nest egg.  This will generate income when the working years of drawing the major paycheck come to an end.  The planner then compares the number to where his client is in terms of savings and other income sources.  More often than not, there is a shortfall in the sense that the retirement goal will not be met unless a return on assets is achieved that exceeds the return on so-called capital preservation type assets (savings accounts. money market funds, CDs, Treasury bills, etc.). To make up this shortfall requires greater savings, working past the desired retirement date, or achieving a higher return. To the extent the first two choices aren't attractive leaves the higher return goal which, in turn, necessitates taking on risk in the investment markets for most retiree wannabees.

The intelligent management of risk via asset allocation, then, becomes the focus; and this is what  the country has been struggling with since the demise of the defined benefit plan.