Protect against inflation or preserve capital?

  by Shelley Seagler

A man is lying in his hospital bed, surrounded by friends and family, reflecting on his recent near death experience. “I always thought it’d be the ulcer that killed me. I did everything the doctors told me. I drank the cream, ate the butter, drank the milk. And now I have a heart attack!” This was a scene from the critically-acclaimed original series on AMC, called “Mad Men”, set on Madison Avenue in 1960.

It is also a scene playing itself out in the portfolios of millions of Americans. Like Don Draper’s boss in Mad Men, many of us are fighting the wrong dragon – and killing ourselves in the process.

Capital Preservation Versus Inflation

When I am speaking, I often ask my audiences, “When thinking about your investments, what worries you most?” One of the first answers I hear is almost always, “Losing money!”

Capital preservation is our ulcer. Inflation is our heart attack.

Think about the average Baby Boomer – someone born around 1952. For many of you, that won’t be too tough. You are the average Baby Boomer. Assuming your parents were 25 when you were born, your parents would have been born right around 1927. How do you think that shaped the messages you got about money, and in particular, about investing? How do those messages affect you today?

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Understanding How We Got Here

The dominant financial experience in the lives of most of our parents, and certainly our parents’ parents, was the 1929 Stock Market Crash and ensuing Great Depression. As a result, Baby Boomers were imprinted with certain ideas about money, almost from birth: Don’t put your money at risk, pay off your home, stock market losses are evil.

It is not just investors who are indoctrinated with this belief system. The ranks of financial advisors, financial journalists, and government regulators are populated by this same demographic cohort, with the same belief system, stemming from the same seminal event.

As a result, as we accumulate assets, we become focused – obsessed in some cases – on avoiding capital losses. So, as we age, we start to gravitate toward fixed income securities like bonds. If capital preservation is the ulcer, fixed income portfolios paying 5% or 6% are the cream.

“How so,” you ask?

Your Primary Investment Objective

The first thing you have to understand is the basic fact from which all your investment decisions must follow. Assuming your objective is to someday be able to quit working for a paycheck and live off the proceeds of your portfolio, your life expectancy is the primary determinant of your investment strategy.

Let me repeat that: Your life expectancy is the primary determinant of your investment strategy.

The average retirement age is 62. So let’s consider the case of the average couple retiring this year. The joint life expectancy of a 62-year-old non-smoking couple is 92 years. That is 30 years in retirement.

The Old Good News/Bad News Situation

This is the good news-bad news joke. We are living longer, but that longevity is also one of our greatest risks.

Let’s imagine someone who retired in 1977 with a fixed pension of $20,000 a year. They were probably able to live pretty comfortably too – for awhile. After all, the median income in 1977 was $13,572. In 1977, a gallon of regular gas cost $0.62. The median price for a new home was $54,200.

But fast forward forty years.  Now how well do you think that person is doing on that same $20,000 a year pension? Even with a Social Security check and a paid for house, I can promise you, the monthly income doesn’t go far enough.

So here is where our inherited belief system clashes with our reality. The cost of living rises, in the United States, an average of 3.5% per year. That does not take into account health care, which is rising at least twice that rate.

What about Sustaining a Reasonable Standard of Living?

If you hold a portfolio which returns 6% a year, for example, your real rate of return, or the return left after inflation, is only 2.5%. This is not enough to sustain any reasonable standard of living over a period which will likely span 30 years of retirement.

The only way to sustain a reasonable standard of living over that long of a time period is to earn a real rate of return higher than that paid by so-called “safe” investments. In short, your long-term standard of living is directly correlated to the percentage of your assets you place in what has traditionally been thought of as the riskier asset classes, like stocks.

And therein lies the conundrum. To live comfortably, you must do the thing that you fear, which is put your capital at risk – because profit is the reward for risk. Without risk, there is no risk premium. You must earn the risk premium to be able to live when you no longer have a paycheck.

Facing Stock Market Risk

That is the bad news. Here is the good news. In spite of what you may think, in spite of what your gut might tell you, and in spite of the belief system passed on to you by your parents, there is, effectively, very little risk in the stock market for the long-term investor holding a reasonably diversified portfolio. Market risk only exists in the short term.

Let’s say you’re 47. For planning purposes,  you can assume you will live to the age of 102. In other words, you must build my portfolio to do its job for 55 years. If you plan to hold an equity-based portfolio for that long, what risk do you have? Not much.

Will you experience temporary declines in your portfolio value? Of course. Markets are cyclical. They go up and down – sometimes a lot. But at the end of 55 years, how likely is it that your investment will not have grown at a rate that exceeds the total return on bonds?

Therefore, your choices are really quite simple. In order that you not run out of money, or at least purchasing power, you must commit a substantial portion of your assets to an equity-based investment strategy and keep them there for the long term – through the ups and downs – all of the panic buying and selling. The only way to make the required return is to always be in the stock market. Not market timing. Not stock picking. Holding a portfolio of quality companies over your entire lifetime and that of your spouse.

For most of you, that is not easy. It will never be easy. It goes against programming imparted to you almost at birth. But you have to do it anyway. To do otherwise is to guarantee a heart attack by treating the ulcer.

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