Life is full of risks.
Many have esoteric names. Like longevity risk, the risk of living longer than your money. Or credit and maturity risk in bonds. Then there’s manager risk, sector risk, market risk and country risk in equities.
When you put it all together, there’s portfolio risk— the odds our financial assets will lose value over some period of time.
All these risk measures have one thing in common: They put people to sleep.
They do this because they are abstractions, geeky stuff that’s useful for decision makers who manage money. A bit like intense discussions of tire tread design or cookware construction, the technical risk measures are useful for those in the trade, but less than fascinating to normal human beings. Even longevity risk, the primary worry of boomers approaching retirement , seldom gets beyond dark humor about cat foot diets.
So I’d like to introduce another measure.
Laurence J. Kotlikoff, a professor of economics at Boston University, calls it Living Standard Risk. It is the probability (and amount) our living standard can decline over periods of time. The risk we face depends on our total resources— things like our home ownership, Social Security, investments, and possible pensions.
You’ll be hearing a lot more about this risk measure, and soon, because using it produces very surprising rules for investing. One is a big reversal: The poor should invest in stocks. The affluent should be more cautious.
To understand, let’s compare two retired couples. The Affluents have a $5 million investment portfolio, a home with a large mortgage, and Social Security benefits. The Scrapers have not been so fortunate. Like the Affluents, they have Social Security benefits. They own their home outright. But their portfolio is only $50,000.
The conventional wisdom says the Scrapers should be cautious CD buyers. The Affluents, on the other hand, should own lots of stock. In fact, nearly the reverse is true. The Scrapers can afford the risk of stocks because their investments contribute only a small part of their standard of living. Most of their living standard comes from their Social Security benefits, the fact that they own rather than rent, and that they have no debt to service.
The Affluents, on the other hand, need to worry about the risk of equities because most of their standard of living comes from their investments. Worse, they need to service their mortgage debt with income from their investment portfolio. If they suffer big market losses— as in the 2000 to 2002 bear market— their standard of living would be permanently reduced.
For the Affluents, the riskless benchmark is the lifetime income they could get from a portfolio 100 percent invested in Treasury Inflation Protected Securities, otherwise known as TIPS. Recently, these were yielding about 2.3 percent over the rate of inflation. That’s an income of $115,000 a year. It’s also about half the spending rate commonly suggested by financial planners.
The Affluents, in other words, enjoy a higher income because they are taking the risk of investing in equities. That means their standard of living could fall much further than the Scrapers.
Bottom line: The greater your wealth, the more you should consider risk.
This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
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(c) A. M. Universal, 2007