Tricky Questions About Financial Risk

True or false: Investing in the stock market is riskier than heading to the bank and purchasing a CD?

 

Actually, this is a trick question because the answer is: It depends! It depends on what you mean by “risk.” When investing over the long haul, there are two types of risk to consider.

 

Investment Risk

When you invest in the stock market, your holdings might go up (reward) or they might go down (risk). These gains or losses show up as real dollars that you can see in your monthly account statements, and they can be exciting or scary to watch, depending on which way they’re headed. That’s investment risk.

 

Hands down, it is absolutely true that you face a lot more of this type of investment risk by participating in the stock market than by purchasing CDs or similar kinds of “fixed income,” where a penny saved is highly likely to be a penny earned. For better or worse, your CD’s monthly statement will pretty much look the same every month.

 

On the other hand, by investing in the stock market, you are expected (although not guaranteed) to earn more real return than from purchasing fixed income such as CDs — if you stay the course and stoically accept the required investment risk. Historically, that equity risk premium has been around 5 percent per year.

 

Compare this to inflation, which has been around 3 percent per year … and which brings me to my next point.

 

Inflation Risk

While stocks are more vulnerable to investment risk, fixed income is far more vulnerable to inflation risk, or the risk that the purchasing power of your money will decrease over time in the face of inflation.

 

Think of it like a leaky bucket, in which the drops of water being added (such as CD interest) aren’t enough to compensate for the hole in the bottom (inflation). Or, for a real example of how inflation impacts your spending power, consider the price of postage. It cost you $0.06 in 1970 versus today’s $0.44 to deliver the same letter.

 

Inflation risk can wreak havoc on your wealth. There are periods, sometimes lengthy and severe, during which purchasing power is so diminished by inflation that “safe” investments actually yield significant negative real returns when measured with their ability to keep pace with inflation. In addition, inflation risk is insidious, because the damage doesn’t show up us obviously negative numbers in your monthly returns statements. Dimensional Fund Advisors’ CEO David Booth provides a fascinating presentation on the subject, which I recommend you view for more details and specific data-driven illustrations on the subject.

 

Let’s return to our true/false question: Are stocks “riskier” than CDs? As is so often the case, the truth seems to lie between the two extremes. The best way to manage risk is by building a well-diversified portfolio that controls for inflation risk with equities and dampens investment risk with fixed income.

About the author

Tom Posey, CFP®, J.D., AAMS

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