The humorist Will Rogers said it most famously: “I’m not so much interested in the return on my money as I am in the return of my money.” (In fact, Mark Twain had expressed exactly the same sentiment first, many decades before the Great Depression.) Their point was that it is more important to be made whole than to enjoy the benefits of capitalism by always coming out ahead.
Inflation and longevity risks
If only it were so simple! Just getting investment funds back — while definitely welcome — is not enough. Investors also need to protect the inflation-adjusted purchasing power of the money they have committed.
Depending on the rate of inflation in any given period, investors may believe they are treading water while, in fact, their buying power is steadily eroding. Their mistake is to confuse the “nominal value” with the “real value” of their holding, i.e., the monetary amount after inflation is deducted. From day to day, it is easy to neglect how far inflation has quickly eaten into an investment, erasing real returns. Sometimes real returns will even turn negative.
For instance, suppose you invest in a fund or stock that carries a nominal return of 4%, which probably sounds decent enough. But what if inflation is running at 2%? Normally, 2%, considered to be an extremely healthy rate, is a level the central bank would indeed love to see. In that case, you would need to deduct the 2% from 4%, leaving you with a much slimmer return of a mere 2%.
At the same time, retirees face the separate longevity risk that they will need far more money than anticipated to support a longer retirement. Actuarial estimates show that among 60-year-olds, the majority will live to at least 80. And about a quarter of Americans live to 90 or older. All those years must be funded, with health and assisted-living costs always on the rise. Seniors will need some return on capital in addition to return of capital.
Some safer instruments
A trade-off is inevitable. The more secure the financial instrument, the lower the return is likely to be. That said, at certain times, investors seek primarily capital preservation when they perceive little growth potential in the near future. To accommodate, some instruments are not designed for growth at all but to park money to be available when needed.
Some safe vehicles mainly for shorter time horizons include:
- Treasury bills
- CDs
- Checking accounts
- Savings accounts
- Money market funds
- Short-term municipal bonds
- U.S. savings bonds
- Agency bonds
- Fixed annuities
Another, more-structured route exists for hedging risk with capital preservation funds. While these are based on unique configurations, the basic formulas limit both returns and losses. The “secret sauce” is that the fund invests in customized options. By illustration, a fund might offer a return of X% while capping any losses at Y%. In other words, if the S&P 500 were to decline 10% over a specified time period, investors would see no return at all but be shielded; if, however, the index rose 15% during a banner season, investors’ gains would be contained to an upper limit.
An anchor strategy
Most investors need to combine some growth with capital preservation. A diversified set of blue chips, held in a tax-efficient manner, usually outperforms under a long-enough time horizon. Too much loss aversion can be damaging, as shell-shocked investors discovered after 2008, when they missed the extended subsequent rally.
Consider a balancing act by dividing your portfolio into two parts: one conservative (like CDs) and one growth-oriented (like exchange-traded funds). If the market implodes, the conservative anchor should help maintain your starting level. Knowing your principal is protected might also boost your confidence to invest somewhat more aggressively.
This is just the beginning of a discussion you need to have with your financial, legal and tax advisers to make sure your investing strategy aligns with your overall estate plan.