The Risk of Playing It Too Safe

Most people feel the pain of losing to a much greater magnitude than the pleasure of winning. In fact, psychologists find that losses are twice as powerful as gains on an investor’s psyche. They call it “loss aversion.” In this month’s cover article, What Risk Is — And Isn't, investment pro Howard Marks describes dealing with risk as “the essential element in investing” and notes that “most level-headed people want to avoid or minimize” risk. The greater an investor’s desire to avoid loss, the greater will be his or her desire to avoid risk.

Minimizing risk, of course, is the driver behind many money management fundamentals. For example, the idea that everyone should maintain a reserve of money in an ultra-safe savings account is to minimize the risk of a financial emergency, such as a job loss or an unexpected major expense.

When it comes to investing, diversifying one’s holdings rather than putting all of your eggs in a single basket helps minimize the risk of being overly concentrated. This type of advice is appropriate and helpful.

However, sometimes the riskiest thing you can do financially is to play it too safe. Here are a couple of examples.

To better prepare for the future, investors nearly always need to accept some degree of risk. In this case, even the extremely conservative step of buying an annuity with an inflation rider involves some risks. An annuity would likely provide her with a higher monthly income while also locking in some inflation protection. However, her cost of living could still rise faster than inflation, and if she were to die soon, it would leave her heirs with less due to the cost of the annuity.

Alternatively, SMI might suggest that she invest her savings, using a 50/50 blend of Fund Upgrading and Dynamic Asset Allocation. A conservative allocation could have 20% of her Upgrading portion invested in stocks and 80% in bonds. Further, both strategies have downside protection built in.

Either way, the risks of action must be weighed against the risks of inaction.

Investment risk certainly should be managed, and to whatever degree possible, minimized. No one gets bonus points for taking more risk than they need to. However, sometimes the riskiest thing you can do is to play it too safe.

The Risk of Playing It Too Safe

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