Imagine a brainstorming session in Detroit going something like this:
Cars have gotten so expensive, why don’t we add an alarm to provide increased protection against theft?
Great idea! It wouldn’t cost much in relation to the value of the car and people might feel better about leaving their vehicles parked. We can provide additional security for very little cost.
And buyers were indeed persuaded by the idea of having redundant security: the added protection of a movement-sensitive alarm. In reality, however, what auto makers (and aftermarket suppliers) provided was more the appearance of security than actual protection. In a paper published by the Columbia Journal of Environmental Law, author Steven N Brautigam, JD, estimated that over 95% of all car alarms that sounded in New York City were false, caused by ‘vibrations of passing trucks or glitches in the car’s electrical system’. Knowing that most such alarms are ignored, thieves even set them off deliberately, using the noise to cover the sound of breaking windows to steal items.
Right now, you may be wondering how car alarms relate to financial planning. Both share the element of security theater: the appearance of security rather than its reality.
In nearly thirty years of helping people make their financial decisions, I’ve yet to meet someone who has no concern for the safety of principal. In fact, most people seem to be interested in a strategy that could be called conservative: preservation of capital through eliminating risk. While I appreciate the concept of investing in CDs and US Treasury obligations to try to protect assets, I believe there’s also risk inherent in that approach.
Here’s a chart from Dimensional Fund Advisors, that helps illustrate my point.
You’ll notice that the lower grey line tracking inflation and the teal line tracking the return on short term government investments (T Bills) are perilously close to one another. If you take the $21 you’d have received from investing one dollar ‘conservatively’ in 1928 and adjust it by taxes there’d be around $16 to spend on something that would now cost $14 due to inflation. That’s a very narrow margin of safety and means that you’d basically need to save every dollar you plan to spend later in life.
We understand that investors lean towards CDs and Treasuries because they want to avoid risk. At WWA, we look at risk differently. We encourage our clients to assume moderate investment risks during their working lives rather than facing the risk of outliving capital through an expensive illness or an unexpectedly long lifespan.
DFA’s chart is logarithmic so even though the other three lines aren’t very far above the teal one physically, they are quite far apart numerically. For example, extending the maturity of the chosen bonds will certainly expose an investor to additional volatility over the short-term but, as you can see from the green line, the approach provides additional protection from inflation over the longer term.
You don’t have to search very hard to find a headline pointing out the risks of investing in the stock market but let’s look at the fine print. Consider the darker grey line above the long-term bond line. It shows that $1 invested in stocks in 1928 would have been worth over $7,300 at the end of last year. At the same time, that line also illustrates the very real (and often very frightening) market movements which are inherent in such an investment strategy. DFA was founded with a focus on investing in smaller company stocks, so the chart’s top line is more important to them than it is to us. While the opportunity for returns is potentially greater in smaller company stocks, volatility is even more pronounced so it’s a sector we utilize with caution.
Does it seem likely that some combination of these investment alternatives might be able to provide a rate of return greater than CDs alone, yet offer manageable volatility along the way? We believe so and it’s the approach we take as we try to provide our clients with true security, not security theater.
Another brainstorming session you might want to imagine takes place at the ostrich ranch:
If we just bury our heads in the sand, there’s no way those lions will be able to find us.
How likely does it sound that lifetime investment goals can be met without considering the ‘lions’ of reality: inflation, increased life spans, Illness and family needs, any of which might disrupt an overly conservative investment strategy?