Distribution of Wealth

I have seen a number of articles recently discussing the growing wealth gap in the United States. There are many reasons for this but I think one of the most important that I have heard is that the rich hold more stock. They hold ownership in companies. They take more risk with their savings. I would point to a few observations that I think everyone should be aware of in regards to this discrepancy.

1. What we think of as "risk-free" actually has a great cost.
2. There are structural considerations for how much risk one can take.
3. What can you do (if you are not rich) to tip the scales in your favor.

1) The risk in "risk free" investing: 

There is no "risk-free" asset. Over time money markets (short term Treasury bonds) have barely kept up with inflation so if we take inflation out of the equation money markets earn you nothing. Yet many consider them a "risk-free" asset. While there may be very little risk that you do not get paid back there are other risks to consider.

Lets do some simple retirement math. A person works from age 25-65 (40 years). They earn $100,000 per year. They save 10% ($10,000) per year. They put all their savings into "risk-free" money markets. When they retire they want to spend the same $90,000 they have been living on for the past 40 years.  How long can they live on their savings?  

We already established that there were no returns (after adjusting for inflation) so their savings totals 40 years X $10,000 or $400,000.  If they continue to spend $90,000 per year, their savings will last only 4.4 years. They will be back to work before they are 70 (a very short retirement indeed)! This is called shortfall risk and it is very high for those who are to afraid to take risk in their portfolios. Recent research shows that the very rich take higher risk in their savings. Why is that and are there things we can learn from the rich?

2) Structural reasons the non ultra-rich take less risk:

There may be good reasons for the non-ultra rich to take less risk. More of our money is tied up in our home. Some savings is set aside for emergencies and should be in less risky assets. We may have less belief that we can easily replace investment losses due to lower income levels. These are valid issues but are there things we can do to lessen the gap?

3) How do I try to tip the scales in my favor:

I will share three things I do to position myself to be able to take on more risk. First of all I view my home as an investment. I do not spend my money making extra payments on my home. The interest paid on my mortgage is very low, gives me tax benefits, and increases the risk of my house investment. Any extra house payments I make would reduce my tax benefit, increase my real estate exposure and reduce my exposure to other investments.  The first way I get more exposure into equities is I stopped paying my low interest rate debts off early and put the money into risky investments.

Emergency savings is very important and needs to be in a safe type of investment because we may need it tomorrow. I have heard advice to hold up to six months of spending in this type of investment, I do not. What is needed in an emergency is liquidity, not cash. I keep about one months worth of spending in cash unless I know of upcoming expenses. I augment this with a credit card that I keep only for emergencies. When/if I ever use it I pay it off quickly. If markets are good I sell investments to pay it off. If not I use the cash flow (dividends and interest) coming from my investments to pay it down. Most importantly I try to not use it. 

Overcoming insecurities about being able to recover investment losses is difficult. Fear makes people get conservative at just the wrong times, greed makes them add risk at just the wrong times. My tactical allocation strategy helps me take advantage of the fear and greed in the market by moving against it when appropriate. Another rule that has helped me to avoid allowing fear and greed to dominate my investing is to never buy a security that is up that day and never sell a security that is down that day. It is amazing the positive impact this simple rule can have on your decision making.

Summary:

There is no such thing as a "risk-free" investment. The often overlooked shortfall risk (not earning enough to meet the intended need) is a less talked about and under appreciated problem in many investment portfolios. Three things that I do to free up assets to take more risk in my investments include 1) not paying down low interest, tax advantaged debt (such as my mortgage or low rate car loans) 2) keeping a smaller amount of emergency savings (augmented by income from riskier assets and a credit card) 3) monitoring my investment behavior to avoid the two financially destructive emotions of fear and greed.

I know some of these pieces of advice run counter to things you might hear from more traditional sources. I would tell you that most of the people giving the traditional advice don't actually follow what they say. They have to give more conservative advice than they often follow themselves (for legal reasons).  For those same reasons, I am not saying you should do what I have done. I am just sharing with you what has worked for me. I hope this gives you some things to think about as you make your own financial decisions.