Risk: The Surprising Reason You Should Make it Your BFF

You'd think it would be difficult for someone who was raised by a safety queen to to embrace and even enjoy thinking about financial risk. I burst into a big grin when I think back to my childhood lessons regarding risk-taking, which were mostly about "not doing (this or that)" due to the fact that I'd be "liable to die" if I did. These lessons were generally being taught when I was doing something I wasn't supposed to, like driving too fast, opening the door to strangers or not making straight A's. But I do -- I love the concept of risk and reward when it comes to investing, and I encourage you to befriend it!

Who in her right mind would want to befriend risk? Isn't financial risk "bad" -- best reserved for greedy corporate types, the frivolous, and gluttons for punishment? It's no surprise that when people hear the word "risk" in conjunction with investing, they often look like they've just sucked on a lemon! It's a natural psychological reaction to something we perceive as negative, but it's not necessarily the right reaction.

Let's pause for a crucial question: Are all risks created equal? The standard (non-financial) definition of risk usually implies a negative connotation -- something along the lines of "exposure to injury or loss". If you're a visual worst-case-scenario type like me, perhaps you are picturing a guy gambling away his retirement fund in Vegas? Or a daredevil skier heading down a sheer cliff? Someone else might simply think of a college grad moving to a new city for job opportunities, or a wife trying a new recipe for dinner. All of these are risks, but they certainly don't carry the same "exposure to injury or loss".

Just as there are varying levels of risk in the real world, there are different types of risk in the financial arena. For example, there's unsystematic versus systematic (industry or company specific versus general or market), liquidity, price, sovereign, and on and on and on. And they do not possess equal exposure to loss.

The good news is the LMF4HMW readers need not worry about the many different kinds of financial risk. The two biggest risks you face are 1) not investing at all or putting off retirement planning; and 2) being too conservative and losing out on market returns. Yes! I need not comment on the first given all my posts about investing now. Regarding the second, the all too common way a retirement portfolio asset allocation is presented and encouraged is as follows: you should hold 100% stocks minus your age to equal the amount of bonds. So if I'm 30, I hold 70% stocks and 30% bonds.

The problem with this approach, other than its inherent laziness, is that it ignores basic factual evidence! In Stocks for the Long Run, Jeremy Siegel, esteemed Wharton professor, educates us that "over the last century, accumulation in stocks have always outperformed other financial assets for the patient investor", or someone with a time horizon of 17 plus years (you unless you plan to expire -- not retire, in less than 17 years).

Given that Siegel's research demonstrates that stocks outperform bonds 90 percent of the time for 20-year holding periods and nearly 100 percent of the time for 30-year time frames, most LHF4HMW readers should concentrate their retirement portfolios exclusively in stocks. While your ride might be a bit more interesting and shaky a times (more up and down), the destination will be superior (better returns or more money).

The idea that stocks are inherently risky is based on misinformation and hype. Think Enron or any other financial crisis. While it's true that an individual stock's value can decline or even evaporate, when you hold a number of different stocks, you mitigate the risk via diversification. Most of you invest in funds via your company's retirement plan, so the diversification part is already covered. (Note: I do not advocate that LMF4HMW should hold individual stocks; for most people, index funds with their low expense ratios are the first choice and mutual funds are the second.)

With regards to bonds (or fixed income), Siegel cautions that it's very common to confuse "fixed income" with "fixed purchasing power". Bonds are not "safer" than stocks; in fact, in 20-year periods, they've lagged inflation at times by as much as three percent. And cash, well, if you put your retirement money in a savings account versus a diverse basket of equities, you can be sure that your nest egg will erode over time, which is really risky.

So I'll gladly swallow the "risk" of investing in stocks for my retirement. In this case, risk is indeed my best friend as it's what will lead to the reward of superior returns!

Now that you've made it through this posting on risk, open a bottle that is void of risk: a yummy Sauvignon Blanc from New Zealand closed with a screw top. Try Kim Craword, Huia or Brancott for some lemon/lime, floral and racy flavors from the Kiwis! (If you're wondering why screw topped Sauv Blanc pairs with today's post, it's because this type of closure eliminates the risk of the wine being "corked", or smelling like sweaty socks :)