Chapter 14: Risk and Money
Last updated
Last updated
Lloyd: “Come on, give it to me straight. I drove a long way to see you. The least you can do is level with me. What are my chances?”
Mary: “Not good.”
Lloyd: “You mean not good, like one out of a hundred?”
Mary: “I'd say more like one out of a million.”
Lloyd: “So you're telling me there's a chance...YEAH!”
– Dumb and Dumber (1994)
Investing in stocks and bonds is your best bet for getting a better return than putting all your money in a savings account. But there’s a hitch. You could end up losing money instead. This is called “risk.” You cannot expect to earn higher returns without taking more risk.
How do you measure risk? Finance geeks calculate how much returns bounce around from period to period. They measure volatility. [32] For example, take the last day of each month since 1946. Look at the total return you would have had if your money had been invested in the S&P 500 stock index over the previous year, ending on that day. In most one-year periods you made money; in some you lost. On average you made about 12%. Very nice. But in one out of five yearly periods you lost, sometimes a lot. The worst was February 2009, when you lost 43% of what you had the year before. If you needed your money at that time, you would have been very unhappy. That’s risk. Here’s a picture.
In the past, the stock market has always recovered from losses. You did okay if you hung in long enough. The same is not true for individual company stocks. Companies often go out of business or get bought by other companies when their stock prices are down. In fact, half of all companies don’t last more than seven years in the stock market. [33] Problem is, you don’t know which half.
Fortunately, there is a simple way to deal with the risk of owning loser stocks: make sure you own winners as well. In other words, own a lot of stocks. Even better, own them all. This is called not putting all your eggs in one basket, or diversification. The quip is that “diversification is the only free lunch on Wall Street." [34] Thanks to mutual funds and ETFs, and specifically index funds, it is very easy and cheap to diversify your investments.
The stock market is risky because it goes up and down a lot. To reduce risk, you put less in stocks and more in less volatile bonds, inflation-protected securities, and cash (i.e., your savings account). The fancy term for finding the right mix is asset allocation.
Figuring out the right asset allocation is the most important part of investing. For the last several years, investors have been in a tough spot. The interest available in safe savings accounts has been miniscule. Like basically zero. So there has been a lot of pressure to take more risk in order to have a shot at more investment income. The question is, can they afford to take this risk.
It helps to think about when different types of investments make sense. Here are some general guidelines.
Stocks: Stocks are good when you want to build wealth over a period of five or more years but you can live with the possibility of ending up with less. Stocks of American companies should be your mainstay. Consider adding some international stocks, both from more developed economies such as Japan, the United Kingdom, and Germany, and faster-growing, “emerging markets” such as China and Brazil. The reason is that different countries’ markets do well at different times.
TIPS or I-Bonds: For far-off goals, such as retirement, put some savings into inflation-protected securities. This is your “safe” money. It won’t grow a lot more than inflation, but we’ve seen that over longer periods the risk that inflation will eat away at the value of your savings is significant. TIPS and I-Bonds are guaranteed to keep up.
CDs: These super-charged savings accounts are for when you absolutely, positively need your money to be there at a certain point in the future. CDs are best for periods up to about five years. You can pick the date you need the money and know in advance exactly how much interest you will earn.
Bonds: Intermediate or long-term bonds (bonds that mature in four or more years) can pay a little more interest than CDs for goals that are more than five years in the future. They fluctuate in value, but much less than stocks. Very short-term bonds (bonds that mature in one to three years) don’t fluctuate as much and can be used to “park” some money and perhaps earn just a bit more than in a savings account.
So much for generalities. What is the right asset allocation for you? I’m going to give you three options for preparing your personal asset allocation.
You can use this worksheet to figure out your asset allocation. Enter your goals, how much you’ve saved to date, and when you need the money. Then think about the four questions below and decide how you might allocate the savings for each goal.
What is the time horizon of this goal? When do I need the money?
Can I achieve it just by saving or do I need a lot of investment income to get there?
How flexible is the goal? Can I postpone it or do with less if I invest more in stocks and they go down?
How much of a risk taker am I? Will I be able to sleep at night if my wealth goes down 10%? 20%? 30%?
The sheet will calculate your total asset allocation as shown in the example below. As a bonus (not shown) it calculates how much more you need to save each month to reach your goal. That depends not just on your asset allocation but also on the return you expect each type of investment to deliver. Assume a higher return and you need to save less, but the risk of falling short increases. The returns in the sheet are expected real returns [35]. You can substitute your own or those of your favorite forecaster. Just don't let yourself off the saving hook by assuming unrealistic returns.
Once you’ve landed on an asset allocation, you need to take your savings and invest. I’m going to list some specific ETFs and mutual funds that are good candidates in each of the major asset classes described above.
The main criteria I used to select these funds are broad diversification and low expenses. Broad diversification to avoid ending up with too many losers and not enough winners in any given asset class, and low expenses so you get to keep as much of the return on your investments as possible.
I apologize if this gets weedy, but if you want to implement the concepts from this chapter you do need to know what specific investments to buy.
The first table below lists ETFs, which means you can buy them in any regular or IRA brokerage account. ETFs are generally not available in employer retirement plans or 529 college savings plans.
Asset Class
Fund Name (funds in each asset class are comparable; choose any one)
Ticker Symbol
Expense Ratio
U.S. stocks
Vanguard Total Stock Market ETF
0.03%
Schwab U.S. Broad Market ETF
0.03%
iShares Core S&P Total U.S. Stock Market ETF
0.03%
International stocks
Vanguard Total International Stock ETF
0.09%
iShares Core MSCI Total International Stock ETF
0.09%
TIPS
Schwab U.S. TIPS ETF
0.05%
Bonds
Vanguard Total Bond Market ETF
0.035%
Schwab U.S. Aggregate Bond ETF
0.04%
iShares Core U.S. Aggregate Bond ETF
0.05%
Vanguard's ETFs are also available as mutual funds. Either way you own the same underlying stocks and bonds. You can buy mutual funds directly on Vanguard's site without opening a brokerage account, but you have to invest at least $3,000 per fund. You might also find them offered in your 401(k) or 529 plans, sometimes with the alternate ticker symbols below.
ETF
Vanguard Mutual Fund
Mutual Fund Ticker Symbols
Expense Ratio
VTI
Total Stock Market Index Fund
0.04%
VXUS
Total International Stock Index Fund
0.11%
BND
Total Bond Market Index Fund
0.05%
SCHP
Inflation Protected Securities Fund
0.20%
I suggest putting 60% to 75% of your stock investments in the U.S. market. Any one of the funds listed in this category is a good choice. The remainder of your stocks should be in international stocks. Again, any of the funds listed will do the trick.
The easiest way to buy inflation-protected securities is through the Schwab TIPS ETFs. There are also TIPS mutual funds and I've listed one from Vanguard. I recommend mutual funds for retirement accounts. If you're enterprising you can even buy individual TIPS in a brokerage account. (Diversifying is not necessary with TIPS, since they are all issued by the government.)
For non-retirement accounts, I am a big fan of buying I-Bonds through Treasury Direct. Like TIPS, I-Bonds are not about earning a high return. They are about protecting some of your savings against inflation. I-Bonds are under-appreciated for several reasons: you don’t have to pay tax on the interest until you cash in the bond (which can be as long as thirty years), you can cash it in at any time after a year without having to worry about the value going down, and you’re protected against both inflation and deflation.
What about CDs? The best way is to shop around for the highest interest rates available on sites such as Bankrate.com. In most cases they will be available either as a regular, taxable certificate or as an IRA. You can buy some CDs through your accounts at Schwab or Fidelity as well. This is simple, but you may not get as good a deal.
Don’t have the time or patience to go through the asset allocation stovetop recipe? Here’s a better-than-nothing short cut. Use a risk tolerance questionnaire such as this one from Vanguard to determine a stock-bond mix that fits your objectives. Then choose a corresponding fund that invests in and maintains your stock-bond mix. Here are some options.
Fund Family
Available Mix (% stocks/% bonds and cash)
Expense ratio
20/80; 40/60; 60/40; 80/20
0.13%
30/70; 40/60; 60/40; 80/20
0.25%
20/80; 30/70; 40/60; 50/50; 60/40; 70/30; 85/15
0.53% - 0.74%
My reservation about these instant meals is that they do not put much money to TIPS. Instead, almost all of the bonds are “nominal”, which is bad if inflation jumps unexpectedly.
Still too much for you? There’s an even simpler approach to asset allocation that’s based just on your expected retirement date (or, in the case of 529 college savings accounts, the college enrollment date): target date funds. These are one-size-fits-all, but they are still far better than letting your savings flounder haplessly in the hinterland. Many 401(k) and 403(b) plans automatically invest your contributions in target date funds, which is good.
Target date funds usually have a future year in their names. For example, the Fidelity Freedom 2050 Index Fund is meant for people who plan to retire around 2050. When the target year is far in the future, the funds will mostly be invested in stocks. As it draws closer, the mix shifts more toward bonds. As an example, here is the planned mix of the Fidelity Freedom Index Funds.
Here are some target date fund options. Both Fidelity and Schwab have two series of funds with similar names. Make sure to use the index fund series, which have lower expense ratios.
Fund Family
Target Dates
Expense Ratio
Schwab Target Date Index Funds
Every 5 years 2010 – 2060
0.08%
Fidelity Freedom Index Funds
Every 5 years 2005 - 2065
0.12%
Vanguard Target Retirement Funds
Every 5 years 2015 – 2065
0.13%
Once you have determined your asset allocation and how you will invest, write it down. [36] One page is all you need. Having it on paper will help you remember, stay the course, and avoid making impulsive decisions.
Following is what a plan might look like (Chapter 26 explains the reference to “ESG” funds):
If you cook your own asset allocation you should rebalance periodically. This simply means recalculating your actual allocation, comparing it to your target, and adjusting if necessary. For example, assume your target for stocks is 50%. If stocks plunge, your total portfolio will go down, but stocks may end up being just 45% of the lower total. Bonds (or other assets) will now be above target. So you sell some bonds and buy stocks to get back to target. Use this simple worksheet to calculate how much to buy and sell.
Why rebalance? It keeps your portfolio from becoming riskier or less risky just because of market moves. In normal times, rebalancing once a year is enough. When there are large market moves it makes sense to check in quarterly. Don't overdo it. If you're within 5% of your target allocation it's fine to leave things alone.
One benefit of asset allocation funds (the microwave recipe) and target date funds (the happy meal) is that they do the rebalancing for you automatically. You literally don't need to look at your portfolio for years— and that can be a very good thing.
All fund information in this chapter from company websites as of 2/16/2020
(VITNX, VSMPX)
(VTSNX, VTPSX)
(VBTIX, VBMPX)
(VAIPX, VIPIX)
