Two Different Risks
The other day, I dropped my 3-year-old daughter off at preschool. As soon as I got her out of the car, she saw a friend and began to dart across the parking lot. Frantic, I sprinted and grabbed her by the arm. There was no “close call,” but letting my daughter run across a parking lot is simply a risk I will NOT take as a dad, no matter how slim the odds of an accident are.
Later that day, this same daughter of mine was playing with a skateboard in our driveway. Knowing the coordination level of a toddler, I was confident she would get hurt.
As I watched this unfold, I did something that initially went against my “protector” mindset as a dad – I let her play with it anyway. With the helmet on and no cars present, she was having fun and experimenting. Lo and behold, just minutes into playing with the skateboard, the wheels went out from under her, and she fell on her backside. A little whimper, a little scratch, and…she got up and went right back to the skateboard.
In a sense, I took a risk as a dad. My precious daughter, the one I swore I would never let get hurt on my watch – got hurt.
But there are two key things in play here… 1.) The risk was not catastrophic (i.e., she could recover, however long that might take), and 2.) The short-term risk led to a long-term reward…in her case, it was resilience, grit, and coordination.
Risk Defined
In the dictionary, risk is defined as “the possibility that something unpleasant or unwelcome will happen.”
I have the pleasure (and great responsibility) of stewarding client capital for families, small businesses, and non-profit organizations. In addition, I speak to many other investors each week.
When I speak to these investors and the term “risk” is used, they are typically describing the possibility of a sharp downward movement in their money. To some, this might mean -3%. To others, it might be -25%. The dollar amount or percentage may vary, but investors most often define risk as a short-term phenomenon. Rarely do I hear investors talk about risk in the context of a long-term event.
So, allow me to submit a new definition of financial risk: “The possibility of not reaching one’s goals.”
The Biggest Threat
What is the biggest threat to a happy retirement? Running out of money. Imagine a retiree enjoying a comfortable lifestyle for a decade, only to realize their income can’t keep up with rising costs and future tax bills. This is the silent risk of inflation and unplanned taxes, eroding purchasing power over time.
A Slow Boil
Many readers are likely familiar with the boiling frog metaphor. If you toss a frog into boiling water, it’ll immediately feel the pain and jump out. But if you toss a frog into room-temperature water and slowly heat the water, it will sit there and boil.
Many of us do all we can to avoid the pain of the boiling water (think volatility of the market), not realizing that the larger risk is, in fact, the slow boil of our after-tax income not keeping up with the rising cost of our expenses.
Real World Example
Picture a 65-year-old retiree with $2m in investments. She spends $100k per year, equating to a 5% withdrawal rate from her portfolio.
With interest rates around 5%, she might consider placing all $2m in a money market or fixed-income product. $2m earning 5% earns $100k of annual interest, after all. But diving into this further, let’s explore three reasons why a seemingly low-risk investment may prove to be a silent killer over the long run.
- The interest on cash products held inside a taxable account (i.e., Trust, Joint, or Individual) is taxed at the investor’s marginal income tax rate as Ordinary Income. For a high-income earner in a high-tax state, these tax rates can push 50%.
- If short-term interest rates decrease (widely predicted in 2024), cash will experience a corresponding decrease in income.
- There is no growth of income. Cash simply pays interest – there is no potential price appreciation.
Even if interest rates stayed at 5% (unlikely), our retiree above would still only be receiving $100k/yr in interest in her 90’s. But due to inflation, the price of her cup of coffee nearly doubles. The end result? Her income falls far short of her spending needs.
Blurry Binoculars
Let me be clear… I’m not here to bash money markets or advocate for everyone to go all-in on stocks. Choosing your investment mix should always be done with discernment and a deep understanding of your income requirements, tax situation, liquidity needs, and overall financial goals. After all, someone with 30+ years left has different needs than someone entering their twilight years.
However, we need to adjust our financial binoculars. We need to focus less on the blurred foreground and more on the horizon. The short-term gyrations in the market are anything but clear. But focusing on the horizon (10, 20, 30 years from now) allows us to look past the blurry foreground.
If we are indeed long-term investors, two of the most critical components of success will be… 1.) Will my income outpace rising costs throughout my life, and 2.) Have I planned & managed my future tax liability? It’s the amount we take home that matters, after all.
Avoiding Downside, Missing Upside
In The Bahnsen Group’s annual white paper, David Bahnsen states, “A portfolio strategy intended to avoid all downside volatility is one that will miss upside, as well.”
Relying solely on low-risk, low-return investments can be detrimental in the long run. We must honestly ask ourselves, “By avoiding short-term volatility, am I putting my long-term goals at risk?”
For the readers… Is your focus on short-term volatility clouding your ability to plan for longer-term risks? What are you doing to prepare for your cup of coffee doubling in price? How are you planning for taxes, not just in 2025, but in 2045?
Blaine Carver
Private Wealth Advisor
bcarver@thebahnsengroup.com
Trevor Cummings
PWA Group Director, Partner
tcummings@thebahnsengroup.com
