Thursday, March 6, 2008

The Biggest Risk You Face as an Investor

Investors face all kinds of risks in the financial markets.

There is credit risk – the risk that a borrower will default on an obligation. Liquidity risk – the possibility that you will not be able to convert a security into cash when you need the money. Market risk – the likelihood that the stock market will decline in value.

But the biggest risk of all is shortfall risk. This is the risk that you’ll outlive your savings. And it is quite real.

Thanks to better lifestyles, improved nutrition and advances in health care, folks today are living longer than ever. People retiring at 65 face the serious prospect of spending up to three full decades in retirement.

That means investors using an ultra-conservative approach, investing in Treasuries, CDs and money markets, are often taking a bigger gamble with their portfolios – and their retirement lifestyle – than they realize. This is especially true when you consider the thief that robs us all, inflation.

All Signs Point to Higher Inflation

The “headline” consumer price index (CPI) for the year ending in January was up 4.3%, the third consecutive monthly reading above 4%.

Of course, the “core” CPI, the one that excludes volatile energy and food prices, shows a 12-month rise of 2.5%. That’s not yet dramatic enough to grab the headlines. But there is likely more bad news on this front dead ahead.

Why? Let’s start with the perpetually weak dollar. The ailing greenback raises the cost of imports, allowing domestic producers to bump prices higher without the threat of foreign competition. That’s inflationary.

Then there is the Federal Reserve. The 2.5% core inflation rate is above its so-called comfort zone. Yet, transfixed by the credit crisis and the housing slump, the Fed has brought rate down 2 points. And stands ready to cut rates further. This, too, is inflationary.

Need confirmation? Look at what is happening with inflation-adjusted Treasuries. (A handy way to follow them is to track what is happening with an ETF that holds them – like the iShares Lehman TIPS Fund, symbol: TIP). Over the past six months, TIPS have taken their biggest jump since they were created by the federal government 11 years ago.

The gold market is signaling higher inflation, too. The “barbarous relic” has been hitting one new all-time high after another lately. And it’s not just a short-term phenomenon. Gold is up more than 225% over the last eight years.

Some consumers shrug and say, “What difference does it really make if inflation bumps up another point or two?” Don’t make that mistake.

With a 4% inflation rate, an income of $100,000 is worth only $70,000 after nine years. After 17 years its real worth is cut in half. After 30 years, it only has the purchasing power of $30,000.

Investors planning for retirement might be unpleasantly surprised to see the $100,000 investment income they counted on generating only $30,000 worth of purchasing power. And that’s before taxes.

Don’t Bail On Stocks

So what do you do? First off, don’t let the bears scare you out of the market. Stocks can be nerve-wracking in the short term. And they can always go lower before they go higher. But stocks are an incredible wealth-building machine over the long term. For time periods measured over a decade or more, nothing has beaten the returns generated by a diversified portfolio of high-quality common stocks.

As I’ve been telling Oxford Club members, junk bonds sport attractive yields now, too. A raw materials fund that tracks the performance of the Goldman Sachs Commodity Index is not a bad idea, either. And blue-chip gold-mining shares are another fine hedge against inflation.

But don’t bail on your stock portfolio. If you jump out of the market, where will you put all that money to work? In Treasuries yielding less than 4.5%? In money markets whose yields drop with every rate cut by the Fed? Into real estate, which is in a downward spiral?

I’m not saying these investments don’t have a place in your portfolio. But you have to maintain a balance – and a decent weighting in equities.

In short, if you want your retirement years to be truly “golden,” common stocks are still your best protection against shortfall risk, the biggest risk you face as an investor.

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