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Wednesday, July 25, 2012

Joe Learns About Risk - In the School of Hard Knocks

Suppose you had enough money to put in Treasury notes so that you could live off the interest.  Would you be set for a risk-free, secure retirement?

You probably have guessed that the answer is no.  I found over the years, however, this wasn't an easy argument to make.  There were people who would show me their portfolio - 100% U.S. Treasuries - and explain that they could retire on the interest.  They would then say that they were taking no risk.

This is where the professional can add value.  He or she points out that there are different kinds of risk. Granted that U.S. Treasuries have zero credit risk, but they do have interest rate risk, reinvestment risk, and inflation risk. Let's examine this.

Joe - the First 10 Years

Let's go back 20 years.  Let's meet Joe, a composite of many who have approached me over the past 20 years to talk markets and investment strategy.  Joe explained that he didn't have to take risk because he had diligently saved and now, in 1992, had his assets all in the 10-year Treasury note throwing off $40,000/year.  Along with Social Security, he was looking forward to a great retirement.  Joe was 60 years old.

In 1992 the 10-year Treasury note yielded 6.73%.  Joe had $595,000 invested in 10-year Treasury notes to produce $40,000/year income.  In 2002, when the 10-year Treasury matured, the yield on the 10-year was 4.49%.  Now his $595,000 was producing $26,715.  Uh oh!

But this wasn't nearly the whole story.  Inflation had eroded the value of the dollar over this 10-year period to $0.78!  Thus, the $26,715 was equivalent to $20,837!  Thankfully, his Social Security had kept up with inflation; but, sadly, ten years into retirement and Joe had to change his lifestyle in a big way.

As an aside, you see a lot written about retirees running out of money.  In real life, what happens is they change their lifestyle.  In other words ,if they make mistakes, then it means they don't eat out as often, take the trips they planned, repair the roof, etc.

Joe - the Next 10 Years 

The ensuing 10 years saw Joe's position deteriorate even more.  Today he has his Treasuries maturing and the reinvestment rate is 1.43%.  Furthermore, inflation has significantly eaten into the real spending power of his Treasury Note interest.  Joe is 80 years old and in a precarious position.


I tried to explain to Joe when he was 60 years old that there are different types of risk.  I suggested (pleaded, in some cases) for him to put at least 30% in a well-diversified equity portfolio.  I tried to explain that, by doing so, he actually reduced his risk.  Incidently, $100,000 in equities would have grown to approximately $400,000 today.  But, my advice to Joe was mostly to no avail.  He had his mind made up.

Today, of course, I see people all the time who have their money in money market funds.  Some are fully invested in CDs.  They tell me they don't want to take risk.  Some things never really change.

1 comment:

  1. Some people think the way to avoid risk is to hide under the bed. Of course that's little help when the roof caves in. Sometimes its better to go out into the risky world and earn enough to build a stronger roof.
    Thanks for stopping by.