The Dumbest Question in Investing
By Lee Kranefuss[1]
There is one question that gets asked – and gets asked over and over – that I think is the dumbest question in investing. And the funny thing is it’s not a question asked by investors; it’s a question the investment industry asks its customers. And it goes something like this:
How comfortable are you with risk when investing?
- Very comfortable.
- More comfortable than most investors, but not the most comfortable.
- Somewhat comfortable.
- About as comfortable as the average investor.
- A little less comfortable than average, but not very uncomfortable.
- Quite a bit less comfortable than most, but not the least comfortable.
- Very uncomfortable.
Or some variation on this. The question is asked, of course, to try to match you up with an “appropriate” fund or strategy.
But this question makes absolutely no sense.
Why?
First, this is a nonsensical, metaphysical question no one can answer – what are you supposed to do? peer into the souls of others to determine how much fear they carry around about markets to compare?
But more important, this question is irrelevant. Because it really doesn’t matter how comfortable you are with stock market risk when investing: the reality is you must take on enough of it to get the returns you need to meet your financial needs. The tail does not wag the dog.
Here is an analogy. Suppose you have a big social event – a wedding, reunion, or some such – that is going to happen in exactly three months. You want to look your best, and want to lose 25 pounds. If you go to a dietician, no one who is competent is going to ask you “how comfortable are you with hunger?” It’s a stupid question: hunger is, by definition, a state of discomfort. No one is comfortable with hunger. That’s what makes it hunger.
What a dietician could tell you is how many hours a day you would need to spend on a treadmill, and how much (or little) you could eat each day to meet your goals. Now, you might look at that and say “I can’t tolerate that – it’s too uncomfortable for me.” Fine. But the end result is you will need to show up a bit heavier than you wanted. In setting time-based goals the universe doesn’t care at all what you want or are comfortable with. You need to adapt to it, not the other way around.
Now let’s look at this with an investing example.
Suppose you just had a child. And suppose you want your child to start private college in 18 years and graduate with no debt. Four years of private college costs about $200,000 today; with 4% inflation that will be about $440,000 in 20 years. Now suppose a wealthy (but stingy) uncle says, “I will give you $65,000 today to invest for your child’s college education.” And, for the sake of argument, let’s suppose you are so financially strained that you don’t feel you can save anything on your own for that college education – now or in the future.
Right now, “safe” government bonds deliver, at most, 3% for a 20 year bond. Over the last 50 years, the U.S. stock market, in comparison, has delivered 10% per year, or a bit more, over the long-run.
Here’s the rub: if that $65,000 is going to become worth $440,000 or so in 20 years, then it must earn an average return for 20 years of around 10%. There is nothing deep there: it is simply using a calculator.
So what does this tell you? If your goals and needs are as I described them, you have no choice but to put 100% of the money in the stock market. Only if you can get an average 10% return can you turn $65,000 into $440,000 in twenty years. It doesn’t matter how comfortable you are with the risk of the stock market, or how much more comfortable you would be with bonds, or some mix (like a 60/40 portfolio). Your resources, savings and needs drive how much return you need, and that drives how much stock market risk you will need to suffer.
However, if you were fund shopping for a way to invest that $65,000 and you chose #7 above, chances are you would be steered to bonds. But if you buy a 20 year government bond today with the $65,000, it will be worth less than $120,000 when you need the $440,000: you will guarantee falling $320,000 short of your goal (which, by the way, ought to make you very uncomfortable – but that part of investing comfort is seldom discussed).
Of course we never have things that are so crisp and clear. But the reality is that there is a maximum amount you can possibly save every year. And there are future needs – downpayments for homes, sending kids to college, retiring – that will be pretty big numbers when you total them (especially with inflation).
If you are very good with a spreadsheet you can work all these backwards and determine what the minimum return is that you must make from your investments to be able to pay for all those things. If that number turns out to be 9%, then if the stock market can deliver 10% on average and bonds can deliver 3%, then investing 86% in the stock market and 14% in bonds will get you there, because 10% x 0.86 + 3% x .14 = 9%. (I believe, by the way, that stocks can continue to deliver 10% or so. Many people disagree with me, projecting 7% or 8%. You can use whatever number you like – but the end result will be you will need to save more, spend less, and take on even more stock market risk if you agree with them and not me.)
Whatever it works out to, there is some amount that will need to be invested in stocks for your entire lifetime. And, if you feel you “must” shift more to bonds as you age – as many target date funds do – then you need even more savings exposed to stock market risk earlier in life. As you can see, it doesn’t matter how comfortable you are with anything; the amount of return you need will determine the amount of stock market risk you need to have and get comfortable with.
In the end, many investors invest too little in the stock market because they have trouble stomaching the short-term gyrations. But, if you really work out the numbers, you will likely find that – until very late in life, most likely – you have no choice: you will need to be heavily invested in the stock market to have any hope of meeting your goals.
Opinions expressed are current opinions as of the date appearing in this material only. While the data contained herein has been prepared from information that The Kranefuss Group believes to be reliable, The Kranefuss Group does not warrant the accuracy or completeness of such information. This communication is for informational purposes only. This is not intended as nor is it an offer, or solicitation of any offer to buy or sell any security, investment or product.
Copyright © 2019, The Kranefuss Group and/or its affiliates. All rights reserved.
[1] Lee Kranefuss is CEO and Founder of The Kranefuss Group LLC.