We hear the terms “safe asset” or “risk-free asset” all the time in the world of investing.
Generally, these terms are used to describe FDIC or NCUA insured deposits like checking accounts, savings accounts, and certificates of deposit (CDs) or Treasury bonds issued by the United States government.
If we define risk simply as the likelihood of losing our investment principal, then it is indeed true that these are not “risky assets.”
For all intents and purposes, you can be 100% confident that you will get your money back*.
[pullquote align=”left or right”]…the guarantee that you will not lose your principal…is simultaneously a guarantee that you will not have enough money to live the lifestyle that you want in retirement.[/pullquote]
However, this one-dimensional definition ignores a much more important conversation that we should be having about risk.
Namely, the risk that investing in such an asset may very well prevent us from reaching our future financial goals (or future liabilities).
For example, let’s assume that your financial plan says that in order to live the lifestyle that you want during retirement, you need to save 15% of your annual income and earn 5% per year on your portfolio.
In order to achieve this rate of return, an appropriate asset allocation is likely to include a mix of both stocks and bonds (both of which can be considered a risky asset).
Let’s say for sake of argument, the portfolio consists of 60% in stocks and 40% in bonds.
However, what if instead of investing in such a portfolio, you decide to keep 100% of your money in your checking account?
Possibly because you can’t seem to forget the turmoil from the last bear market.
Or maybe because you don’t have a financial plan to help you understand what you need to do in order to be successful.
In either case, you are essentially conceding that you will not be able to achieve your financial goals.
More specifically, the guarantee that you will not lose your principal (since it is safely tucked away in an FDIC-insured checking account) is simultaneously a guarantee that you will not have enough money to live the lifestyle that you want in retirement.
The only way to achieve your goals in this “risk-free” scenario would be to save more or work longer.
The other option would be to reduce your lifestyle in retirement (although I don’t know very many people who are excited by that idea).
When looked at this way, an FDIC insured checking account can indeed be considered a risky asset.
Now let’s return to the portfolio of 60% stocks and 40% bonds and pose a few questions:
Will there be volatility in such a portfolio?
Is it possible, even likely, that during your investment horizon such a portfolio could decline 30% or more?
Does such a portfolio give you a far greater chance (although not a guarantee) of reaching your financial goals?
For most of us, taking risk with our investments represents a balance between willingness and need.
Almost all of us need to take investment risk during our lifetime, because without it we won’t be able to achieve our financial goals.
Savings alone is not enough.
However, our need to take risk must be balanced with our willingness (or tolerance) to take risk.
This is where a good financial plan can be so valuable.
If you have a solid emergency fund to float you through a period of uncertainty and you are not drowning in debt, you are in a much better position to handle risk.
Said differently, a good financial plan can ensure that your day to day life would not be affected except in the most extreme scenarios (allowing you to sleep much better at night regardless of your portfolio).
However, a huge benefit that cannot be overlooked is that being in such a position allows you to take greater risk in your investment portfolio.
Thereby, giving you a far greater chance at reaching your goals.
It is for that exact reason why bringing a solid financial plan into your investment picture gives you the highest odds of success.
*Subject to FDIC and NCUA insurance limits in the case of deposit accounts and assuming you hold the asset until maturity in the case of a Treasury bill or bond.