If you are retired or on your way to financial independence, then you have assets. You’ve stockpiled wealth in some form. But that wealth is embedded in an always fickle, sometimes hazardous world.
To preserve your assets, you need to understand the variety of financial risks. Then, you need to prioritize them. Every risk has a probability and a cost attached to it. Some are likely, while others are highly unlikely. Some are relatively easy to protect against, while others would be extremely expensive or impossible to prevent. Understanding these differences is key to optimizing your financial safety.
Retirees face risks to their financial security on a variety of external fronts. One of the most prominent is “the economy” — the net result of the commercial interactions of billions of human beings. Those humans tend to group into large institutions — governments and corporations — and that spells trouble. Most people, most of the time, are great neighbors. But these large institutions acquire power and use it to transfer resources from one favored group to another. Or they defend their own interests, instead of the general welfare.
Other risks that retirees face are internal. Sometimes we are our own worst enemy. This is especially true when it comes to: earning, spending, saving, and investing, or not. The vast majority of us consume all our resources the moment we receive them, unable to save for financial freedom. Those of us who manage to put aside savings still face a psychological hurdle: Can we invest it wisely? Will we succumb to gambling, in some form, with our hard-won wealth? Or will we invest in good value, diversify, keep costs low, and exercise patience?
Now, let’s look at each of the specific risks that can impact wealth. We’ll start with the smaller, internal risks, and progress to the larger, external ones. Then we’ll talk about which risks are cause for greatest concern….
The fundamental risk is ignorance or inexperience. We’ve all wasted money through benign neglect or active blunder. The best scenario is to make these mistakes, and learn from them, early in the game — with small amounts of money. One of the most important investing lessons is how to deal with routine recessions and market volatility. An experienced ship captain knows the safest place in a storm is out at sea, riding the waves. The novice who tries to bring their assets into port during each squall runs the risk of being dashed on the rocks. Thought-leading author and financial advisor William Bernstein calls this “shallow risk.” With experience, it turns out to be little risk at all, if you exercise patience.
The next risk is bad information. This follows from ignorance. If you realize you don’t know enough, you’ll naturally seek education and advice. The world, especially the electronic world, is bulging with financial advice, products, and services for sale. Without a filter or some friendly guidance, your chances of finding beneficial information are poor. Virtually every successful investor I know, including me, has followed or bought lousy advice, at some point. That’s one way we learned. Even with trustworthy advice, the complexity of our financial world can work against your success. Applying information to your personal situation can be difficult, requiring more expertise than some do-it-yourselfers can muster, and more time and integrity than many paid advisors will offer.
That brings us to the next set of risks, which we’ll group under the label rigged game. This is the ever-present reality that the financial system we use, the accounts we think of as “ours,” even the dollars they contain, are merely abstract financial tools in the hands of others. A simple example, which none of us can escape, is investing expenses and fees. You cannot put your money into play without paying somebody first. In the best case, that’s a transparent, low cost. In the worst case, it’s a hidden, high, and continual drag on your assets. Beyond those fees that we can’t escape, there is high-frequency trading, insider trading, and outright fraud, which can all reduce or destroy assets. These are the risks of using a financial system that was designed and constructed by powerful interests for their own purposes.
Taking that rigged game to a unique level is government, which has ultimate control over the rules by which we all must play. Government is the only entity that has the legal right and the enforcement power for confiscation of our assets. This primarily occurs through taxation, but can take more aggressive routes if we run afoul of the laws that our majority-elected politicians create. Few financial topics are as contentious or complex as taxes. Our byzantine tax code is a set of rules created over time by those in power to encourage behaviors they deem important. None of us can escape taxes, and we are each affected to varying, often misunderstood, degrees.
Now let’s move on to economic risks: We live embedded in an economy and monetary system that is subject to cycles. In 2008/2009, we saw a low point: The Great Recession. Had that episode gotten worse, it likely would have turned into depression/deflation. That’s when business activity grinds to a halt, and the prices of goods and services fall, because nobody can afford them. The few that have cash are fearful of spending it. True deflations are rare. The modern world, led by a bevy of central banks, is afraid of depression and its destructive social consequences, and has proven skilled at avoiding it. Bernstein says that in this fiat currency era, there is very low risk of deflation. Thus it doesn’t make sense to hedge against it to the same degree as other risks.
The opposite of deflation is inflation — a general increase in prices. This often occurs because money is cheap to borrow, resulting in more dollars chasing goods and services. At its worst, inflation deteriorates into hyperinflation, and the value of a currency is quickly destroyed. Most of today’s economic policymakers consider a certain amount of inflation a good thing: 2% annually is often used as a “reasonable” target. This means the playing field for cash, which most investors instinctively assume is “safe,” is automatically tilted against you. Many pundits consider high future inflation to be a given. They argue it will be the only politically palatable way to dispose of our massive public debt without onerous taxation. Yet we’ve been hearing the same arguments for more than a decade, and high inflation has yet to appear.
The last risk we’ll catalog here, though certainly not the least, is deterioration in our physical environment. Bernstein calls this devastation. The traditional sources are violent conflict: war, social unrest, crime. Also, natural disasters such as hurricanes, earthquakes, floods. These events threaten personal safety and/or property on a wide scale. They reduce wealth, or wipe it out. Now, there is a new form of devastation on our horizon. It’s a direct result of the rapid increase in the world’s population. When I was born, there were about 3 billion people on the planet. Today, there are about 7 billion. We are living on a finite resource, and there is less of it to go around than there used to be. Experts are discussing a possible secular decline in growth. That seems like simple, inevitable math: One planet divided by a relentlessly increasing population of insatiable human beings.
So, we’ve defined the major risks to our financial security. But before we react, before we start moving assets around, we need to discuss probability. How likely are these various unpleasant scenarios?
Harry Browne, a groundbreaking thinker in these realms, chose a set of asset classes so that at least one would thrive under any possible scenario — prosperity, inflation, recession, deflation. His Permanent Portfolio had equal quantities (25% each) of cash, gold, long-term bonds, and stocks. And that portfolio has performed well enough in recent decades. But some say it can be improved. Bernstein points out that Harry equally weights all the risks. But that doesn’t correspond to reality. If the risks are not equally likely, then you shouldn’t spend equally to combat them….
How likely are the risks I’ve outlined? Ignorance, bad information, and the rigged game are risks that we all face, every day we have our money in the system. We cannot escape exposure, thus we should do everything in our power to reduce these dangers to our wealth.
Weighing the other risks I’ve discussed often turns into a political brawl. Some think confiscation and taxes are the big issue. Others think it’s devastation of the planet. Some don’t care. For my money, inflation and scarcity are the issues ahead. But, for our purposes here, and for your own benefit, let’s skip the political debate. When it comes to stewarding your personal assets, does it matter whether you agree with others or not? Decide on your own priorities, and then take the appropriate action.
In a future post, I’ll analyze specific tools and techniques for safeguarding your wealth in today’s uncertain world. The good news is that there are concrete steps you can take to improve your financial security. The bad news is that there is no ultimate safe harbor. We are all dependent on each other and the institutions we create. In the end, all we can really control is our own actions.