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IF WE WANTED TO design a portfolio that appeals to our worst investment instincts, we might couple a savings account with lottery tickets. Some governments have even issued bonds with just these characteristics.
What’s the attraction? The savings account ensures that part of our portfolio never loses value, while the lottery tickets let us dream of riches in return for a relatively small investment.
This year, we’ve seen the lottery-ticket mentality writ large, as investors take fliers on meme stocks, nonfungible tokens and cryptocurrencies in hopes of hitting the jackpot. For instance, earlier this year, dogecoin could be bought for under a penny—less than the price of a lottery ticket. With a little daydreaming available for so little money, maybe it’s no surprise that dogecoin is up more than 6,000% in 2021, even after this month’s shellacking.
But while this year’s frenzy over fringe investments has hogged the headlines, let’s not forget our other behavioral impulse: our strong aversion to losses. This instinct may not lead to short-term financial disaster. But it can wreak havoc over the long haul. What’s so wrong with trying to avoid losses? It can result in three crucial mistakes.
1. Confusing stability with safety. If we own stocks and stock funds, the market tells us every day what they’re worth. Let’s face it: Most of us would rather not know, which helps explain why we’re drawn to investments where the price seems stable, even if that stability is an illusion.
For instance, many investors prefer individual bonds to bond funds, because they know precisely what those bonds will be worth on the day they mature. What about the fact that this maturity value may be far lower because of inflation, or that we may get some quite different value if we sell at any time before maturity, or that we’re banking on a single issuer rather than getting the broad diversification offered by a fund? It seems many folks happily overlook these drawbacks in return for the illusion of safety.
Similarly, many investors are drawn to the certainty offered by equity-indexed annuities and tax-deferred fixed annuities, even though these insurance products require locking up money for many years and investors could face steep penalties if they exit early. A lack of daily price information is, I suspect, also part of the appeal—as it is for both real estate and venture capital investments. Until we go to sell, we don’t really know what a piece of real estate or a private business is worth—and that allows us to imagine the price is marching steadily higher, with no need for us to lose sleep.
2. Chasing yield. In the quest for psychological comfort, some investors focus not on price, but income. If a bond, stock or other investment kicks off a generous and predictable stream of interest or dividends, we can imagine it’s super-safe. Sometimes, that may be the case.
But often, that regular income disguises an otherwise dicey investment. Take General Electric, once considered to be the archetypal widows-and-orphans stock. In 2009, GE qualified as a “dividend aristocrat” because it had increased its dividend for 32 consecutive years. That, however, was also the year it slashed its dividend amid the financial crisis. Today, the stock pays just a penny a quarter, down from a high of 31 cents.
Over my career, I’ve seen yield-chasing investors torpedoed in countless investments, everything from option-income funds to short-term multi-market income funds to high-yield junk bonds to bank loan funds. The regular income gave the illusion of safety. But eventually, the price of these investments told another story, prompting many investors to panic and sell.
3. Forgetting taxes and inflation. While some purportedly conservative investments turn out to be riskier than investors expect, there are many truly safe investments, such as savings accounts, short-term Treasury bonds, bank certificates of deposit and savings bonds. Investors shouldn’t ever wake up one morning and discover these investments are worth far less than they imagined.
But they might feel that way 10 or 20 years down the road. With even high-yield online savings accounts paying just 0.5%, investors are looking at falling behind inflation by two percentage points a year over the next five years, based on current inflation expectations. Once taxes are figured in, things would look even more grim.
If you have money you’ll need to spend soon, I see no sensible alternative to holding cash investments and suffering this loss of purchasing power. What if you have a longer time horizon? To outpace the twin threats of inflation and taxes, you need to take greater risk—but you need to do so sensibly. Forget dogecoin and digital cat images. Instead, think total market index funds.
Jonathan Clements is the founder and editor of HumbleDollar. Follow him on Twitter @ClementsMoney and on Facebook, and check out his earlier articles.
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Jason Zweig of the WSJ has a good weekly column on investing. Last week was about I Bonds which pay 3.54% and are inflation protected. If you have extra cash laying around, it’s not a bad place to park it. There are a few restrictions such as minimum hold period of 1 year and you forfeit 3 months of interest if you redeem within 5 years. Per person max is 10,000 per year.
Mr Clements, it may get tiresome at times repeating the same ideas in new ways, but I find these reminders and new examples of old ideas invigorating and useful. For new investors, it’s an important caution, for us more…ahem.. experienced investors, it’s helpful to see a new twist on an old idea. Great article!
Everybody wants the same thing, safety, yield and stability, which of course does not exist – at least not in one vehicle or asset class. Perhaps we should return to Ray Lucia’s old buckets of money concept. Separate your money into say three or four piles (or more), and assign a level of safety, yield and stability to each pile and and invest accordingly. The size of each pile conforms to your own age, risk tolerance, etc. Seems like a simple way to marry up risk with your personal financial situation and risk appetite.
Jonathan,
My wife has another requirement for her long term funds: ESG. Is there a family of funds OR ETFs you like which provide low cost, broad diversification AND ESG consideration?
thank you
This may help you get started. I am not “recommending” these funds; they were reasonable options a few years ago, but ESG has developed a lot since then. I’ve included the expense ratios AS OF A FEW YEARS AGO. Those ratios may have changed:
VFTSX Vanguard FTSE Social Index ** 0.20%
FNIYX Fidelity International ** 0.20%
PRAPX PIMCO Total Return ESG I2 ** 0.77%
PARMX Parnassus Mid Cap ** 0.99%
I have used VFTSX and like it. It has a growth tilt, as most ESG Large Cap funds do (a lot of non-ESG Large Caps are simply in value oriented segments of the market.) I know very little about FNIYX and PRAPX except that they and VFTSX could be used to create a 3-Fund portfolio (See Bogleheads Wiki.) I suspect there are better options than PRAPX now (with lower expense ratios). If one uses treasuries for their bonds, or any bond fund that excludes corporates, that’s also fairly ESG in nature (l’m going to drop the caveat here that ESG is in the eye of the beholder to an extensive degree, so I’d suggest one look for more than just an ESG label.) The Parassus fund was well-regarded at the time, and might give one some small to mid cap exposure if wanted, but it’s relatively expensive.
You can find some links to various funds in these two articles:
https://humbledollar.com/2020/11/for-goodness-sake/
https://humbledollar.com/2021/04/virtues-vice/
To be honest, this isn’t an area I’ve looked at closely, but — if I were in your shoes — I’d probably check out the funds offered by Vanguard and iShares.
Will do, thanks Jonathan