This article was originally published in December 2020.
The investor’s dilemma faces all of us: if we don’t invest, the purchasing power of our money will slowly decline; if we do invest, we are exposed to the risk of loss. It results in many sticking with cash.
A bank account feels safe. But the purchasing power of cash will erode in time: a dollar ain’t what it used to be. For many, a bank account is seen as the lesser of two evils. After all, investment offers no guaranteed return and no money-back guarantee. And there are always stories of investments that have gone wrong.
If someone is unable to invest in a way that preserves capital, is it any surprise they stick with a bank account? Losing money negates the purpose of investing. It is rational to avoid investing if we do not know how to preserve capital. But it is also rational to learn how to invest in a way that preserves capital.
We can resolve the investor’s dilemma if we can invest in a way that preserves capital over the long term. This offers an investment-style return without the risk of a large and permanent loss of capital. This article considers how to achieve this.
Short-term risk: volatility
For those with a short-term horizon, volatility is risk. A market slump is painful if you need to realise capital within the next couple of years. And market slumps happen from time to time. Investors with a short-term horizon are therefore advised to have a cash reserve.
All investors are at risk of market declines in the short term. But only investors with a short-term horizon need to realize a loss. In the short term, we cannot solve the investor’s dilemma. This is because we cannot both invest and avoid the risk of loss in the short term.
Long-term risk: capital preservation
Risk gets turned on its head when we are considering the long term. Investors with a long-term time horizon are not forced to sell at a loss during a market slump. Risk is no longer volatility because markets eventually recover. Risk is now the preservation of capital over the long term.
Investors with a long-term time horizon want to avoid the risk of a large and permanent loss of value. This is something that we cannot easily recover from.
We therefore need to invest in a way that will make the risk of a large and permanent loss of value negligible. This is how we seek to solve the investor’s dilemma over the long term.
It is hard to hold two contrary ideas on risk at the same time. In the short term, don’t lose money means we need to own bonds and/or cash savings accounts. In the long term, don’t lose money (in real terms) means we need to invest in volatile asset classes like the stock market.
To paraphrase Warren Buffett: Cash is less risky than stocks in the short term, but stocks are less risky than cash over the long term. (Provided you own good stocks.)
In practice, academics and investors tend to view risk only as volatility. In other words, what is the chance of losing money in the short term? Cash feels safe within this context. The hard part is conceptualising that a volatile stock market can be a safe place to invest over the long term.
Performance mitigates risk
Over the long term, the best protection is performance. Investing in real assets will generate a higher return than a bank account. Good performance will lower our exposure to the risk of loss. This is because it builds a performance buffer.
By way of example, a 25% housing slump can happen at any time. But if you bought your house 15 years ago and are up 300% on the purchase price, would a 25% decline matter?