Why “Safe” Investing is Actually more Risky (aggressive investing vs savings/bonds)

So what’s safer in terms of financial security, having $20 million at retirement or just $100k? Does it matter that you have to weather more ups and downs to get to the $20 million? Does it matter that in a market crash, that $20 million could go down to $10 million? Some people would rather have the $100k instead, for the smoother ride, even though you can’t live on $100k in retirement and that means you must continue to work in old age. I argue that it is more risky to invest too conservatively, especially as inflation eats away at the buying power of one’s savings. Many people confuse low volatility with safety and high volatility with risk, but long time horizons cancel out the volatility. What is risk anyway?

The Risk in having Low Returns is Poverty

 [investing vs savings chart]

Notice that even with big stock market crashes, the lowest bottom on the dips are still much higher than just saving in a bank. Bonds would fit somewhere in the middle of these two lines.

With low returns, there is potential for a “not enough money to pay the bills” risk. Inflation at 3% per year also eats away at the actual purchasing power of your money, thus conservative investments give negative return. You have less and less inflation-adjusted money over time.

Imagine the $100k scenario. What if you become disabled? If you eventually need long term care? Big hospital bills? Sending kids to college? Inability to hire a lawyer when you really need one? If you can’t fix the car in time, it will cost more in the long run. Same with termites in the house. Same with your health. Quality of life goes down and you live in constant fear of not making it through the month. That mentality of being in survival mode to keep your head above water, of not falling through the cracks into forgottenness, what happens to your lighthearted easy-going personality? There would be anxiety, anger, and resentment against society. Vicious cycle of poverty! I’d rather take the $20 million dollars by investing correctly in the first place.

Scenario

If you invest $75k in a savings account or treasury bonds with 1% interest, after 30 years you will have $100k. If you invest in stocks with index funds with a small amount of leverage at 20% annual return, you will have $18 million. With real estate at 25% annual return (BRRR method), you will have $60 million and a whole lot of houses. There are 20 million millionaires in the United States and most of them got there “accidentally” investing in real estate. They lived paycheck to paycheck their entire lives and one day get surprised that they get to take a million dollars out of their old house. There was never much risk. They simply bought an asset that makes money and held onto it for many years.

Last Decade Risk of Investing

In the above scenarios, almost all the gains (>80%) were made in the last decade of the investing. Growth in the first 20 years is slow, and rapidly accelerates as the money grows in the last 10 years. What happens if the last decade before retirement is a bad decade for your investments? The 1970s and 2000s were bad decades with no growth in the stock market, and can happen again.

If your first 10 years were in bad decades for stock investing, you’d only have 15% less money, but if the decade before your retirement is bad, you can have 60% less.

Lifecycle Investing

Two Yale math whizes found a solution to the Last Decade Problem and wrote a book on it. The authors are not investors but mathematicians. I will save you from having to read the book yourself by summarizing it here. Basically, they advocate borrowing a large amount of money to invest when you are young and paying it off when you are in your 50’s. You want your investment to grow as quickly as possible early on as you keep adding more money into the stocks. Most of the risk is handled by the fact that the stock market goes up in the long term.

It has worked 100% of the time in the last 150 years in back testing and increased portfolios at retirement by an average of 63%.

This is essentially what we already do when we buy our homes. We don’t save cash until we can buy the house outright, which would be too expensive. Instead we put 20% down, borrow the other 80%, paying off the bank slowly over 30 years. If we wanted to grow our money more aggressively, we could leverage further by refinancing the house after some years, and use that money to buy more houses (themselves leveraged).

The difference in the stock market is that because it is so easy to buy and sell (anyone can do it for free now), a lot of volatility is created. If you margin too high, you can get margin called and forced to sell your stocks at a bad time. Fortunately, 2X margin in a well diversified portfolio gives the same returns as 5x margined real estate (the typical 20% down) while still being safe. Other methods to borrow money include a cash-out refinance, HELOC, or a bank loan using stocks as collateral.

So while at first glance, investing stocks on borrowed money appears the most riskiest strategy, it is actually the safest of them all because you diversify across time. Check out my article on leveraged investing on what stocks to buy to execute Lifecycle Investing strategy [link].

Why overall stock market will always go up

We have to look at the way stocks work. As long as people continue to put money into the stock you own, the price will go up. Think about the rise of the world’s economy, the world’s population growth, and new printing of money through the Fed’s monetary policy. The labor force is always getting bigger and more productive, increasing the total production (making more money). The world is always developing technologically leading to higher efficiency in production (making more money). There will always be new money being put in, so the stock market will go up over time. Even if a black swan event kills half the world’s population, after some decades we will eventually recover again and so will the stock market.

The stock market itself is becoming more efficient and this is allowing more people to put in their money. In the 1920’s, the vast majority of people did not invest in stocks. Even in the 1980’s, it was difficult to invest. You had to look at the newspaper for some outdated stock price and call your stock broker on the phone, and they charged you $50 per trade, which was a lot of money back then. Now, it’s free and instant, and almost everyone owns stocks. This liquidity makes the market go up even more.

The caveat is that I am talking about the stock market as a whole. If one invests in an individual company, then yes the stock can go down and never recover (ie. MySpace, Yahoo).

Why the traditionally recommended 60/40 portfolio in 401k/Roth IRA sucks

I use the 60/40 portfolio myself, so why do I think it sucks for most investors? Because this only makes sense as I actively rebalance it. In a stock market crash, treasury bonds shoot up, protecting the portfolio. I then sell these bonds for a handsome profit and buy the beaten up stocks at a discount. Then when stock market recovers, bond prices go back down and I buy the bonds back. Many people quickly quadrupled their portfolio during the 2020 COVID-19 crash this way. But for a passive investor, who does not actively rebalance, it makes no sense to have bonds in the portfolio. It’s 40% of their portfolio not making any money.

As with retirement accounts, if you’re a young investor, why would you want your money to be locked up until you reach old age? What if you don’t live that long? Another drawback are the limitations of what you can invest in in such accounts, and the lack of being able to use margin to boost your returns. With a taxable account, you can hold onto your stocks forever, and borrow money using your stocks as collateral for your living expenses. The interest on the borrowed money will reduce any realized gains, and you should not have to pay much in taxes if at all. This is how Elon Musk, Mark Zuckerberg, and Jeff Bezos avoid paying any taxes in most years. To Elon Musk’s credit, he did pay some taxes in 2017 though at only 3% tax rate.

Even if you do end up selling some stocks in a taxable account, most of it is long term capital gains at a significantly lower tax rate than ordinary income. Remember that 401k is taxed at ordinary income, which could be as high as 63% in California, which I live. Doesn’t that suck? People assume that they will be making less money in retirement but in reality the opposite is true. You are poor when you are young and wealthier when you are older, so 401k is a flawed investment product. You still need to take it if there is a company match, but I recommend focusing on a taxable account.

When not to do Lifecycle Investing

If you have compulsive investing tendencies, such as getting into a stock at its peak after hearing all your friends making money from it months ago (late to the game), and then panic selling when it drops, then stock investing might not be for you.

Key Takeaway

The key takeaway is to invest based on sound mathematical principles rather than traditional advice that many financial planners parrot as “safe”. There is no financial security in poverty. 

 

If you want to learn more, please check out How to use portfolio margin for insane gains, and if you're a new investor, check out Newbie's Guide to stock investing article.