I was recently having a conversation about the capital markets with an attorney friend (non-client) who is exceptionally risk averse. Plain and simple, he intimated that he just could not stomach the constant ups and downs of stock prices and the potential for loss of principal. He is not unusual in this respect. Many, if not most, investors share a similar concern. Hence, bonds are his asset of choice.
What was somewhat perplexing to me, though, was that he did not realize or recognize that his risk of loss was just as great in bonds, particularly in the present, low interest rate environment (those in the psych business call this cognitive dissonance). He needs to live off of the return of his portfolio. Most retires are in this situation. We counsel our clients to limit their withdrawals to no more than 3-5% of the portfolio value to reduce the risk of running out of money.
Now think about this. If your portfolio is invested entirely in bonds and earning 2-3% per year, and you are spending 5% per year, this means you are actually dipping into principal by as much as 3% per year. Therefore, over a period of ten years, you will have dissipated more than 30% of your capital. Guaranteed.
Faced with these odds, a nearly guaranteed loss of more than 30% over a ten year period, versus the potential for loss, I can state pretty easily how I would invest my money.
All comments and questions are welcomed.
Bob Bilkie, CFA®