“You can’t have your cake and eat it too.”
As sensible adults, we understand cognitively the truth of this old adage. If there’s a piece of cake on my plate, and I eat it all today, I won’t have any cake left for tomorrow.
The same is true when it comes to investing. Even people who have mastered the skill of saving and investing would like to have their money make maximum returns with little to no risk.
Most of us cognitively understand that this is not reasonable, and that the higher the return the higher the risk. High returns are the compensation one gets for taking an increased risk. Low returns are synonymous with low risk.
This makes intuitive sense, until we add in some actual numbers and the emotional component. For example, today you can earn 1.75% on a one-year Certificate of Deposit. That rate is guaranteed for one year, and then you have to purchase a new CD at the prevailing rates, which do fluctuate. Just three months ago that rate was near 3%. Three years ago it was around 1%. With those low rates, the risk on a CD is correspondingly very low, and it’s almost zero if your account balance is under $250,000 because it’s insured by the FDIC.
If and when you need to start withdrawing a monthly income from your CD’s, you face a conundrum. Let’s say you are 60 years old and have saved $600,000 in CD’s. You need a steady income of a flat $18,000 a year, which represents 3% of the initial $600,000 balance in the account. If the CD’s are paying 1.75%, that means you will deplete your principal by at least 1.25% a year for the first year and by increasing percentages over time. At age 100 you will have $170,744 left.
Suppose you were able to earn 5% a year in a diversified portfolio of asset classes on that same $600,000, also beginning at age 60. With the same $18,000 a year withdrawal, at age 100 you would have $2,050,000 left—over ten times as much as with the CD’s. This means you could have enjoyed a steady annual income of $33,500, almost double that from the CD’s, to have the same amount left as with the CD’s. That’s a significant increase and could make the difference between a retirement of abundance or one of scarcity.
When I present this data to a class on investing and ask, “Who wants the guaranteed lower income of the CD?” usually no hands go up. When I ask, “Who wants a chance to double the income?” I see most all the hands in the room going up. Nearly everyone would prefer to have twice the amount of “cake.”
But what are the risks if you want to earn 5% and potentially double your income? The short answer is you need to be comfortable opening your account statement and seeing a 25% decrease in value in any one year. Being emotionally comfortable with such fluctuation is tough—even when you understand cognitively the strong probability that you will have much more money in the long term when you accept that risk.
The bottom line? There is is no way to count on being able to have your investing cake and eat it too. To provide a strong probability of having sufficient income/cake to meet your needs in the long term, it’s essential to accept the risk that from time to time the supply of cake in the investment “bakery” will fluctuate.