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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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The difference between the inflation rate and your investment return is called real returnOne of my main tasks as a financial planner is to help people figure out not only their goals and the reasonable risks they need to incur to reach The Scourge of Inflation One risk that does not get the attention it unfortunately deserves is inflation. Inflation risk simply means that a dollar isnt worth what it used to be. What does inflation have to do with investing? A lot. If you want real growth in terms of buying power, then your investments have to outperform inflation. Inflation is insidious, sneaky, and in the long term a possible killer to your financial planning. The difference between the inflation rate and your investment return is called real return. Its kind of like in football, where no matter how many yards you gain, if you cant score a touchdown or a field goal you wont have any real victory. Hopefully, everybody reading this book will live to age 67 and beyond. If you had lived the past 67 years, here is how inflation has affected you (years 1934-2001): First class postage went from 3 cents to 34 cents, an increase of 1,033 percent. The average automobile went from a cost of $1,436 to $17,120, an in crease of 1,092 percent. A day in the hospital went from $12 to $2,808, an incredible gain of 23,300 percent. Recently, the inflation rate has not been too high, only 3.4 percent for 2000 and 1.6 percent in 2001, according to the U.S. Department of Labors Bureau of Labor Statistics. But historically it has been much more painful. Table 2.1 shows the lifetime annual inflation rate for various periods. If you Presume an inflation rate of 3 percent going forward, you need to make sure that your game plan accounts for that rise. Stocks are a great defense against inflation because their earnings reflect the prices of goods and services. But bonds, so-called fixed incomes, dont reflect price fluctuations. To the extent your portfolio is in fixed income investments or cash, you need to consider the risk of inflation as you plan to meet your goals. Those goals, but also their risk tolerance: the risk that they cant take risk. All the formulas in the world are useless if youre filled with dread each day over whats happeningor not happeningwith your money. Thats why this inquiry is critical before delving into the numerics of the game plan. Think of it as the calisthenics an athlete does before the actual game begins. To help you figure out your risk tolerance, Ive presented a list of questions very similar to the ones I pose to my clients. I use these questions to help clients design an investment strategy that they can stick with. If theyre risk-averse investors, I dont want them to get too uncomfortable on the downside. If theyre risk takers, I dont want them to get too antsy about missing upside. Why the customized tweaking? Because if either extreme happens, the investor will bolt from the plan. And thats where trouble happens. As you take this quiz, dont try to pick the right answer. Try to be honest with yourself based on how youve acted in the past, or how you think youd act in the future if youve already had some experience. Thats the only way youll be able to create a game plan that will work for you. Before you begin, think broadly for a bit about how you would describe your ability to handle investment risk. Try to draw up, mentally or on paper, a descriptive statement. For example, I cant handle losing money. The ups and downs of the market really bother me. Or I know I have to take some risk, but I would consider myself a pretty conservative investor. Or I get the idea of long-term investing and cant even be bothered paying attention day to day. Risk Quiz As you answer the quiz questions, write down your responses. Each time you choose a letter, give yourself one point for choosing an A, two points for a B, and three points for a C. 1. Your portfolio is invested partly in low-risk bond funds (about 40 percent) and partly in broadly diversified stock funds (about 60 percent), according to a long-term game plan. Its late spring, and this year your stock funds are not doing well. Theyre down about 5 percent, pretty much in line with the overall market. Wall Street analysts are divided on the markets future. You . . . A. Sell all of your stock funds and move the money to bond funds or cash. B. Stick with your allocation despite your current jitters. C. Would never be in bonds in the first place! 2. In the mid 1990s the S&P 500 funds posted double-digit re turns37 percent in 1995, 23 percent in 1996. Looked good to you, so you invested, too. Here are the returns on that investment for the next five years: 1997199819992000200133.2%28.6%21.1%-9.1%-12.0% During this period you . . . A. Cant take the pain of 2000 into 2001 and sell. B. Decide to hold through all five years. C. Bolt in 1999 for a tech fund posting triple-digit returns. 3. Your core fund with most of your investment money has returned about 9 percent a year over the past five years. But you read about a health-care fund thats returned more than twice that for each of the past two years, and youre impressed with what youve read about the manager. You . . . A. Do nothing. B. Sell 5 percent of your core fund and invest the proceeds in the health-care fund. C. Sell 35 percent or more of your core fund and invest the pro ceeds in the health-care fund. 4. Building on question 3, say you invested 5 percent of your portfolio in the hot-hand health-care fund, and after two great years this one fund now represents 12 percent of your portfolio. You . . . A. Were the one who didnt invest in this fund back in question 3, and you still dont want any part of it. . Sell about half of the investment because, while you still have confidence, you want to take some money off the table. C. Are so thrilled with this fund you add another 5 percent of your portfolio to it. 5. In early 2000, you learned of a tech fund that had been up 185.3 percent in 1998 and 232 percent in 1999. You invest. By the end of 2000 the fund has lost 76.3 percent, and few expect tech to rebound anytime soon. You . . . . Would never have touched this fund in the first place. B. Sell and take the almost 25 percent of your investment youve got left. C. Stay the course while you watch another 70 percent of whats left disappear in 2001. How did you score? Everyone falls somewhere on the risk spectrum, as seen in Table 2.2. If you have only 5 to 7 points, then youre likely the type of investor who feels more comfortable giving up potential gains on the upside to cover your backside. Youre risk averse. If you tallied 13 to 15 points, then youre an opportunistic investor who wont be satisfied unless youre getting some piece of the moments action. Youre a risk seeker. If you have 8 to 12 points, youre the in-between type wholl be pretty content with a steady course. Youre risk steady. Should everyone aim to become a B? While it never hurts to try to temper emotional extremes, at a certain point that effort is counterproductive. If Ive got a client whos queasy regarding the market and wants out, like person A in question 1, I may offer some reasons why I believe the investor ought to stay in. But if those reasons are not persuasive, ultimately I wont argue a person out of a decision. Thats like trying to tell someone to forget about a headache: Just dont let it bother you! Well, if it is bothering you, then youre the one who has to live with that pain. Youre the one who has to decide if its worth it. The second step in creating a game plan is figuring out your risk tolerance. Are you risk averse? Risk steady? Or a risk seeker? These arent rigid categories, but by now you should have a feel for where you generally fit. You want to make sure theres no gap between the risk youre taking in your portfolio and your personal risk tolerance. What will you do with this information? In Step 3, the next chapter, Ill help you figure out your investment goals. Thats a mostly numerical exercise based on what you can save, how much time youve got ahead of you, and what lump sum youre shooting for. But now that you know your risk tolerance, you can put those Step 3 figures into context. If the numbers say you should take X amount of risk, but you know youre the risk-averse type, then you should ratchet down a notch or two. If the numbers produce a kind of steady Eddie portfolio that wont quench your thirst for some upside vim, youve got to build a little more risk into the picture in a way that will meet that need without threatening your overall plan. Were not talking major surgery here. Just some tweaking around the edges to make sure youve got the right plan for you. |
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