The decision to invest in stocks or other risky assets depends on factors such as age, savings, and personal needs. If you’re well into retirement, have substantial assets, and don’t have a specific requirement to leave a significant inheritance, you might want to avoid investing in stocks altogether. This is particularly true in today’s context, where real interest rates on Treasury rates are the highest in years and provide virtually riskless returns. For many other people, however, investing in stocks often represents the most direct approach to increase savings and ensure that assets won’t deplete prematurely.
While most investors acknowledge that taking on investment risk primarily serves to prevent financial insecurity in later years, the concept of “financial insecurity” varies among individuals. Merely ensuring basic sustenance in old age may not suffice for many; rather, they aim to enhance or at least maintain a certain quality of life throughout their entire lifetime. These personal objectives require careful definition and assessment against reality. Not everyone can aspire to the levels of wealth seen in individuals like Warren Buffett or Jeff Bezos. Some may need to adjust their expectations and redefine their lifestyle goals in order to achieve a financially secure life, tailored to their unique circumstances. What constitutes hardship for one person may represent abundance for another.
Know thyself and thy goals
Regardless of your specific goals, achieving them often boils down to three factors: your age, your current assets and the lifestyle you want. In certain combinations of these factors, it may be preferable not to invest at all, while in other cases, investing becomes crucial for realizing those goals.
To illustrate this idea, let’s consider an extreme example. Imagine a 75-year-old individual who is single, has $10 million in the bank, and owns a mortgage-free home. This person’s idea of happiness revolves around taking long walks with their dog in the park and volunteering at the local church or library. In this scenario, the individual may not need to subject themselves to any market risk. A 30-year treasury bond with a 3.75% yearly coupon could provide them with an annual income of $375,000, fully preserving their principal. Would that person require a significantly larger income?
This is where financial theory can complicate matters. One common definition is that a rational investor will always prefer more over less. In technical terms, when faced with two assets offering the same probability distribution of future payoffs, a rational investor will always opt for the one with the lower price. This can lead to decisions that detract from achieving your goals, rather than advancing them.
An investor walks into a bar
To see the problem, consider a practical example: An investor walks into a bar, longing for a beer after a long day. The beer costs $10, which is exactly what the investor happens to have in their pocket. However, the bartender presents a choice: the investor can either buy the beer or gamble the $10 in a coin toss. If the investor wins the bet, they receive $40, but if they lose, they get nothing. Essentially, the bartender is offering a discounted game worth $20 (50% chance of having $40) for just $10. According to financial theory, the investor should take this game since it is worth twice what they have in their pocket.
However, there’s a catch. The investor may end up with nothing if they lose the bet, whereas their initial goal of having a beer was all but assured. Increasing their wealth was not the goal, so introducing risk did not align with the original objective, and in fact detracted from it. The undervalued game has a lower utility than the sure beer.
This example can be applied to the case of the 75-year-old individual we previously mentioned. Some advisors may recommend that the investor deploys at least a portion of savings in stocks, considering that the average yearly gains in equities is about twice the 3.75% coupon of the 30-year bond, but it’s essential to question what this actually achieves. It does not improve on the goal of ensuring that the portfolio doesn’t run out, but it introduces the possibility that it could fall short if stocks were to experience a severe, prolonged slump. Investing in stocks would only make sense if the investor’s stated goal was to increase their portfolio for specific reasons, such as legacy goals or bragging rights. Otherwise, blindly pursuing “more rather than less” makes little sense when doing so could seriously affect the investor’s ability of reaching their goals.
Don’t take risks you don’t need to take
In general terms, a higher level of portfolio risk is suitable for younger investors who need to accumulate assets and who anticipate growing needs in the future, such as buying a house or funding their children’s education. On the other hand, older investors who have already built a substantial portfolio and have simpler needs may find it less appropriate to take on significant risk, or any risk at all.
Begin by defining your goals and then determine the minimum level of risk necessary to achieve them from your starting point of age, assets, income and objectives. The objective of investing isn’t always about maximizing your portfolio or outperforming the market. While those can be valid goals, if your primary objective is to achieve financial freedom and potentially leave an inheritance, seek assistance in quantifying that goal and the minimum level of risk needed to achieve it. You may be surprised to discover that you don’t need to expose your portfolio to excessive risk – or to invest in stocks at all.
Read the full article here
