I read this story about a couple planning their wedding – let’s call them Carl and Vanessa.
Vanessa wanted the ceremony to be held in a park next to a lake, but it would be several kilometres from town. The problem, practical Carl said, was there were no buildings in the vicinity should the weather turn stormy – after all, it was common for violent thunderstorms or hail to occur at that time of year.
Carl suggested that a good site would be his Grandmother’s gorgeously landscaped garden. And, if necessary, the guests could easily run into her large historic home to avoid being struck by lightning or pelted by hail. After much discussion, they did agree on this compromise. The wedding was beautiful, and all had a wonderful time.
As it turned out, the weather was warm and sunny – not a cloud in sight – a fact that Vanessa occasionally mentions to Carl, with some regret that it wasn’t held in the charming lakeside setting.
This story illustrates the importance of finding an acceptable balance of risk and reward. Each choice will have a consequence. When it comes to your money, the key is knowing what that acceptable risk is to you.
Investment Risk and Reward
Take a look at this chart of stock returns for the past thirty years.
You can clearly see that the biggest reward came from U.S. stocks, but that also presented the biggest losses. Look at the roller-coaster ride of Canadian stocks. That’s why investors choose the green line – the balanced portfolio – which gave a comparable return to Canadian stocks over this time period without the same stomach-churning drops.
The most common ratio is 40% fixed income and 60% of a diverse combination of Canadian, US and foreign equities which provides a buffer when the stock market takes a dive and lowers your overall risk.
This shows investors are getting pretty savvy about their long-term investing strategy, but not so much for short term goals.
Safety of principal vs. potential rewards
I hear comments all the time from investors who don’t want to keep emergency funds, or savings for short-term goals in accounts that pay next to nothing when they have a chance of receiving double digit returns by holding equities.
A common retirement strategy is to hold several years worth of cash/cash equivalents for immediate cash flow needs and to ride out any market volatility when people are in the decumulation stage. Recently, financial writers have derided this strategy, stating that holding large amounts of cash can cause a significant drag on returns and make your portfolio non-sustainable in the long term.
So, what’s more important to you in these cases – safety of your principal when you need it, or the hope of higher potential rewards?
Revise your thinking
Instead of bemoaning the hypothetical returns you could be missing, you need to think of your cash savings as the equivalent to an insurance policy.
Like most of us, I have a home insurance policy. For over thirty years I resented paying that annual premium. But, when my basement flooded one year I was very glad I had insurance. It must have cost thousands of dollars to clean up the mess, tear out and replace the drywall and flooring in our 1500 square foot space, as well as replace our furniture and other belongings.
Without insurance that would have come out of our pocket, and it’s very likely we would not have been able to afford to do it all.
Risk of losses is very real. We need to take the necessary steps to reduce our risks to an acceptable and comfortable level, especially with our investments. When your time horizon is short, wouldn’t you rather (wistfully) say, “I could have had a 12% return if this money was in the stock market”, instead of, “I don’t know what I’m going to do. I lost half the money I need right now for my purchase/living expenses.”
I know what I would rather say.