Years ago, I stayed in a hotel on the Las Vegas strip where a message flashing on the big screen out front said “98% wild slots.”
The sign was telling the public that the hotel’s slot machines paid out 98 percent of the money they took in, reducing the “house edge” to 2 percent. By comparison, the typical slot machine has a payback percentage in the 85 to 97 percent range.
There were two ways to translate that “98% wild slots” message:
- It’s the best available payout percentage around
- It’s a 2 percent loser.
I raise that dichotomy now because the way the stock market has been going and the influence of current events has some people looking for shelter with their investments.
The classic, proverbial “risk-free investment” is the 10-year U.S. Treasury bond, currently yielding roughly 2.15 percent, though that could change quickly in response to the current actions of the Federal Reserve on interest rates.
The trouble with a return at that level is that inflation is now at 40-year highs. It hit 7.5 percent in February, measured before the war started in Ukraine, meaning it’s even higher now.
As a result, there are two ways to look at the classic “risk-free” investment now:
- Making a guaranteed 2 percent is better than taking the chance of a loss in a stock market that has dropped more than 10 percent this year.
- It’s a 5 percent or bigger loser, after inflation.
Both of those statements are correct, which is precisely why today’s headlines and market conditions are giving investors a refresher course in risk, and how to analyze it.
Things may feel “riskier” now, but the truth is that risk is ever-present. You can’t avoid one type of risk without accepting another, and current conditions make it that nothing feels comfortable.
The Bloomberg 60/40 Index – designed to show the results for a classic mix of 60 percent stocks and 40 percent bonds – has been getting hammered this year, largely because there aren’t protected ports in this storm.
Of course, plenty of experts feel like the 60-40 allocation stopped working years ago, but that is just further reason for investors to assess risk in building an asset allocation.
No matter which dark cloud you fear the most now, there is no way to quell your fears.
If losing money in the market is your biggest fear and you go all to cash in response, your greenbacks are losing purchasing power to inflation. Meanwhile, if you go all-in on stocks, there’s no denying that the market could go down from here and remain lower for a while.
The way to reduce the risks associated with those fears is diversification, and while it’s not comfortable – putting all your money into whatever gives you the most confidence “feels” best – it’s necessary in times like these.
Here’s a refresher on the risks you are balancing now:
Market risk, or “principal risk,” is the potential for the stock and bond markets to kick you in the teeth, and it’s the big bugaboo for most investors.
There’s plenty to be worried about here with the market already in correction territory and interest rate hikes likely to drop the prices on bonds, so the key is finding the right amount of exposure, relative to other risk factors.
Inflation or purchasing-power risk is in full bloom right now, scarier than at any time in the last four decades.
For most people, this is “risk of avoiding risk,” where a portfolio gets too conservative and can’t keep pace with inflation.
Interest-rate risk is also front-and-center right now. It’s hard to lock in a bank or bond return when rates are rising because you can find out tomorrow that your assets are stuck at what has become a below-average rate of return.
Income risk can be about personal income levels – available jobs appear plentiful, but wage levels aren’t rising particularly fast – or about the chance that an income stream will decline in response to rate changes.
Liquidity risk affects everything from junk bonds to foreign stocks to cryptocurrencies. Anyone invested in Russian markets a month ago understands this clearly; liquidity issues globally are likely to be more commonplace until the war in Ukraine ends.
Political risk is the prospect that the government’s broad policy decisions hit home and impact your finances. It’s about policies ranging from the economic sanctions against Russia to the future safety of Social Security, health-care affordability and more. Given current events, it feels more real than ever right now.
Societal risk is ultra-big picture, world-events stuff. War is the biggest of these big events and we’ve got one, and the responses and what happens next could re-shape global markets for the rest of our lives.
All of those factors combine to increase shortfall risk, the chance that you won’t have enough money to achieve your goals; it’s about you more than the market, meaning that you fight it mostly by saving/investing more.
You might also be facing sequence-of-return risk – the chance that you retire just as the market tanks, reducing your nest egg’s adequacy for a lifetime – or special-situation risk, which is about life situations that need to be paid for no matter what is happening in the rest of the world.
It’s an awful lot of risk, and virtually all those factors have never loomed larger than they do today.
Diversification involves leaning into each of those risks, making sure that no one worry can sink you. It’s about protecting against the downsides rather than maximizing the upside.
Thus, if you’re trying to determine where it’s best to invest “now” or “next,” think about how your biggest worries could play out, and whether you’ve balanced out the associated risks.
If the risks are keeping you up at night, you haven’t addressed them properly.
Plan your strategy so that you can relax no matter the conditions; that’s a big win in these conditions, no matter what the market dishes out next.
Chuck Jaffe is a nationally syndicated financial columnist and the host of “Money Life with Chuck Jaffe.” You can reach him at firstname.lastname@example.org and tune in at moneylifeshow.com.
Copyright, 2022, J Features