Being Too Careful Can Be Very Dangerous.
We've discussed in previous posts that it emotions play a key role in long-term investment decision making. And why wouldn't they? Most long-term investing is done with the goal of providing financial security in later years, and ensuring future security is an emotional issue. Since we seek financial security, it feels as if the prudent investments would be those which are completely safe, with a 'no-loss-of-principal' guarantee - something like a savings account or certificate of deposit (CD). We sense that avoiding volatile investments (like index and mutual funds) is wise because we could lose some of the principal we invest there, especially over the short-term. We imagine that the risk-premium isn't worth the taking the risk.
This emotional urge toward safety reveals an investor's natural tendency to avoid risk, something called risk aversion. The problem is that, by avoiding all risk, you're also passing up the risk-premium the market awards to those who do assume risk. This means avoiding risk typically results in lower annual investment return, especially over the long term. This lower annual return provided by these results in a lower account balance - hence, less cash will be available at retirement. Less money at retirement increases your risk of outliving your money accrued in long-term investment accounts.
Let's look at an two examples:
A) 30 years of risk-free savings, where the return simply matches inflation, preserving purchasing power and guaranteeing principal safety but making no 'real return'.
B) 30 years of equity index investing, providing no guarantee of principal preservation but yielding a 7% annual return (S&P 500 return from 1950-2009).
Assuming one saves $500 monthly, these two approaches yield strikingly different results. "A" yields $180K. "B" yields $585K. Over the 30 years, you are rewarded $405K for taking risk.
So the only remaining question is this: Can you afford to not take on risk?
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