You choose: short term "reward" and long term risk, or short term "risk" and long term reward

 

Whether they want to or not, investors face a basic choice: some options will allow you to achieve your goals, and others won't. To reach your financial destination, you can either:

• get lower returns and save more money over time (thus having less to spend )
• get higher returns and save less money over time (thus having more to spend)

There's no option to save less and get low returns--that won't work.

The difficulty investors face is that they want to take little or no "risk"--avoiding anything unpopular or seemingly scary. But, what if the avoidance of supposed risk prevents you from reaching your goals?

A beautiful drive in the country can be pleasant, but if it doesn't your destination, then it's the wrong route. You can make valid choices among routes that will get you where you want to go, but you can't successfully ignore whether the route will get you there.

With investing, you need to clearly understand your options, you must flesh-out the pro's and con's of each, and then you must choose your path.

Right now, investors face a fundamental choice between risk and reward. On the one hand, you can choose options that will likely do well in the short run and terribly in the long run. On the other hand, you can choose options that will will likely look unrewarding in the short run, but ultimately be much more rewarding in the long run. The choice is between: 

• cash (including checking, savings, CDs, etc.)
• bonds
• commodities
• stocks
• real estate

Cash and bonds will likely do well in the short run and be an unmitigated disaster over the long run. Cash and bonds have done well over the last 30 years as inflation and interest rates have gone from mid-double-digits in the early 1980's to low-single-digits now. This process simply cannot repeat (going from 2% inflation to -11% inflation?). This means cash and bonds may look good in the short term, but will almost certainly provide terrible returns over the long run. To choose cash and bonds, you must either be able to perfectly time the point when inflation and interest rates change direction, or you will not reach your financial goals.

Commodities are likely to do well in the short to intermediate term, but then drop like a rock at some indeterminate point in the future. Commodities have done very well over the last 12 years and are likely to continue to do so over the next 5 to 10 years. In the not-too-distant future, though, they will fall off a cliff and provide investors with very poor long term returns. Any observation of long term (inflation adjusted) commodity prices will make this abundantly clear. Like with bonds, commodities will go from great to terrible very quickly, and unless you can time that switch perfectly, you will not reach your financial goals.

Another option is stocks. Stocks have done poorly over the last 12 years, and are likely to provide unexciting returns over the next 5 to 10 years. The outlook beyond that, though, is bright indeed, with 10%+ average returns. The problem is that very few investors are willing to look beyond the short term--or their wished-for ability to time the market--to reap the much better long term results from stocks.  

The last option is real estate. Real estate has had a dreadful 6 years, and is obviously an unpopular place to invest right now. The returns from real estate are likely to be much better than cash, bonds and commodities over the long term, but the short term looks unenticing. Real estate is another choice with little short term upside, but good long term reward.  

To me, the choices seem clear. Cash, bonds and commodities provide short term "reward" with significant long term risk, and stocks and real estate provide short term "risk" with real long term reward. If you want to reach your goals, and don't suffer from the delusion you can time the market, then stocks and real estate are clearly the best options.

If your financial plan permits lower returns, real estate is likely to be a less bumpy ride. If you require or desire higher returns--and the vast majority of people do--then stocks are the best option.  Choose wisely.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Bonds and cash just aren't that safe

Bonds are seen as safe. So is cash. But, that's not necessarily true.

For starters, bonds and cash are susceptible to higher tax rates than stocks. Whether anyone likes it or not, interest on bonds and cash are taxed at much higher rates than dividends and capital gains on stocks. That differential may change with new tax laws, but even then, stocks are likely to be taxed at lower rates.

Most significantly, bonds and cash are more prone to suffer from the impacts of inflation. That may not seem as dangerous as a 50% stock market plunge, but 4.14% inflation over 10 years will do the same thing (and is much more likely to be a permanent 50% loss versus a temporary one for stocks). Does anyone really want to bet that inflation won't be above 4% over the next 10 years considering huge government debt and budget deficits?

Finally, bonds and cash can be defaulted on. This is probably the risk most people dismiss as too unlikely, but a low likelihood is not the same as no likelihood. Bonds are more likely to default than cash, and stocks are more likely to go to zero than bonds, but bonds are not without default risk. If you hold government bonds and think they can't default, a re-reading of the history of Germany, Argentina, Russia and the Confederate States of America is in order. Think cash is default free? Check again. History has many examples including Weimar Germany, France after the South Seas Bubble, or any other example of cash not backed by specie (not yet and never aren't the same thing).

Bonds and cash can be safer than stocks, but not always. Bonds are a promise to pay, but that promise can be broken. Cash is a note (debt) issued by the Federal Reserve as legal tender, and that promise too can be broken. Bonds and cash are much more impacted by inflation and have higher tax rates than stocks. They are not without risk.

I was reminded of this recently when I read that individual investors were generally selling stocks to buy bonds over the last year. They are rushing for a safe haven to avoid the pain of another downdraft. In the meantime, they have missed the market rally and are hoping to time the market. The history of individual investors, especially as a herd, being right on something like this is extremely poor.

The very fact that so many retail investors are racing to bonds together as a herd is enough to remind me of how badly bonds and cash can do. The next couple of years are likely to remind investors that not even bonds or cash are completely safe.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.