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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
I think you were being kind when you labeled the first mistake as “Confusing stability with safety.” After reading the section, I think I would have called it “Confusing ignorance with safety.” But that is what I appreciate most about Humble Dollar: You are helping reduce the ignorance in the world. As always, thank you.
Keeping money in FDIC insured accounts may lose value due to inflation, but this inflation loss may be acceptable compared to likely loss or even fear of loss of stocks and bonds losing value.
And what about inflation adjusted treasuries in bond funds? Even these appear overpriced. Is there really any non-risky option in today’s near zero interest rate and ridiculously high PE stock market environment?
Every investment, alas, carries risk — but they’re risky in different ways. Cash investments carry the risk of negative after-inflation returns and the accompanying danger that you won’t amass enough to meet your goals. Stocks carry the risk that we could have terrible short-term returns — and even terrible long-run results, as we’ve seen in Japan.
A summary. Just a funny knock-off of the efficient frontier. Risk of course means variation of return, but loss is something everyone understands and will experience without a willingness to experience some ups and downs.
Is it possible the tremendous demand for our US bonds is primarily caused by foreign investors seeking to avoid negative rates in their own country, so buy US bonds and pray the FX rate doesn’t move against them? Do we have any idea what percentage of our bonds is being bought by foreign interests?
I believe that in times of financial stress, US Treasury instruments act as a global “safe haven”. The US Public (in one form or another) owns about $21T of the total $28T in debt as of late last year. The percentage of debt owned outside the US seems to vary between 25-30% over the decades, but I don’t track it, so that’s just my perception.
I believe the Federal Reserve tracks foreign ownership of Treasurys — and SIFMA makes the data available in spreadsheet form:
https://www.sifma.org/resources/archive/research/statistics/
Very good observations, as usual. I always agree with your investment observations, something which is not true with others. I believe the single greatest myth in all of investing is the “safety” of bonds. I find this is universally true among the non-financial public. If the secular rise in inflation and interest rates most of us expect comes to pass, I’m afraid many will learn about the inverse relationship of rates and bond values the hard way. I also think the most significant contributor to the spectacular growth in equity values in the last 10 years is the very slow death of the 60/40 portfolio. Yet the demand for bonds continues unabated. The demand for the US 10 year seems to be limitless – hence a 1.6% rate in spite of a huge spike in inflation, seen anecdotally almost everywhere. Zero bonds for me. I prefer cash for my safety funds, which have a zero rate risk.
This reminds of a podcast I listened to recently where two 32 year olds expressed their confidence that they have crafted $1.1 million in investments to live off the rest of their lives that would survive any market crash or future inflation and that no matter what, companies would continue to pay their dividends upon which they rely. 🙏🏼
Agree… $1.1M can last a lifetime, but I would hardly feel secure at age 33. The longer your retirement, the higher your risk.
I am not a fan of emojis, but I love the one you put at the end. So appropriate.
Great article! This is an area that I am struggling with now. I’m six years away from retirement and am moving to another state. We sold our McMansion just last week and netted $550k. We are renting in the interim and plan to buy our retirement home in the next few years and make the gradual move to that new location.
My dilemma is where to put that $550k where it is fairly accessible when we go to buy, but still not given up to inflation. With a vague timeline of 1-4 years, Its a tough call!
With that sort of time horizon, I wouldn’t buy anything more adventurous than a high-quality short-term bond fund — and, alas, you will indeed lose ground to inflation.
High quality bond fund may work as there appears to be no move to raise interest rates within a few years. Any rise in rates could drop the value of the funds.Do the funds have greater return than savings accounts? Probably not. Do you want the risk of losing value unpredictably plus inflation risk, or just the inflation risk alone?
Given your intentions, I recommend FDIC insured high yeild savings, money market, or CDs. Split the money into two banks for FDIC coverage.
Good advice in your article.
Where do you keep your safe money (money you can not lose) that you need for retirement spending until you die?
I am fortunate to have access to a TIAA guaranteed fund paying 3% in my 403b account making up 40% of my portfolio. Most non-profit (teachers) employees have access to this account but few use it. This is the only account I have not rolled to my IRA just because of this fund. My ROTH and classic IRA are largely in vanguard stock funds.
I think such a fund is both relatively rare and valuable. I have a stable value fund in my 401k that returns about 3%, and I use it for the fixed income portion of my portfolio, to replace the usual Total Bond type of fund.
I split my “cash” between a short-term government bond fund and a short-term inflation-indexed Treasury fund.
When you say “short-term government bond fund”, I presume you mean an ETF and not actually buying short term government bonds?
When I say “bond fund,” I do indeed mean a fund — but it’s a no-load mutual fund, not an ETF.
Good article. I’ve got my emergency savings in an online savings account yielding about a half a percent. I don’t see better options. Most of my stock holdings are in index funds, including an index-based target-date fund. But I do have some smaller satellite holdings in narrowly focused funds and ETFs I hope will beat the broader indexes. I’ve had mixed success, at best, in that endeavor, so I limit the amount I can invest outside the indexes.