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The Risks Of Not Investing:

A fair number of people I've talked to over the years are deathly afraid of investing in the financial markets, because they think it is far too risky, and view the stock market as something akin to gambling at cards or slot machines in Las Vegas. So they keep their money in absolute safety by depositing it in federally insured savings accounts with their bank. What they don't seem to recognize is the risk of seeking absolute safety for their money. At first glance, the last sentence doesn't seem to make sense. How can keeping your money in absolute safety be risky? Read on, my friend.

I have an acquaintance who refuses to put any of his money in stock market investments, or any other investment for that matter. He has a fairly large savings account, and the closest he has come to investing is to have some of his capital in certificates of deposit. His fear is that if he invests his money he will lose it and have nothing for retirement. Well, it's his money, and decisions about how to employ his funds are his to make, but there are two risk factors he refuses to understand and declines to consider. They are inflation and "opportunity loss."

An opportunity loss happens when you have a chance to improve your fortunes in reasonable safety, but you don't take advantage of that chance. About ten years ago another guy I know bought a property overlooking the Pacific Ocean and with an eye toward building a house on it. Had he done so, his total expenditure would have been in the neighborhood of four hundred thousand dollars; and, given that Pacific coast property with a great view of the ocean is not likely to lose value any time soon, his money would have been nice and safe. Today the house would be valued at about one million, five hundred thousand dollar. He didn't do it because at the time, there were a number of sound reasons having to do with needing to live in a different location that led to his decision to sell the property. He made a profit on the sale, but missed a really significant chance to do a lot better. His "loss" in this instance works out to be about one million dollars. That's opportunity loss.

OK, OK, I admit that's a pretty dramatic example-maybe too dramatic because most of the chances you and I have to improve our assets won't involve that kind of money; but it certainly does illustrate the meaning of the term, "opportunity loss."

So, you might ask, how is it that my friend is taking an opportunity loss since he is saving his money in a Federal Deposit Insurance Corporation (FDIC) protected savings account? He's not going to lose his savings, is he? No, he won't lose the money he's saved, but he won't do as well as he might have done either. He isn't taking advantage of opportunities to increase his capital in relative safety for the retirement he is so concerned about. He is preserving his capital, but only just barely preserving it.

The other critical risk factor has to do with inflation and it's effect on buying power, so let's talk about that for a minute. We'll take a look at historic inflation rates and savings account interest return rates, going back to 1960 so we can get a long term perspective, and we'll use a table format with the table broken into "decade averages" to summarize the information. Then we will see how inflation erodes buying power.

Decade	Average Savings Rate	Average Inflation	Comparison
1960s	4.30%	2.50%	1.80% above inflation
1970s	5.70%	7.3%	1.60& below inflation
1980s	5.50%	5.10%	.40% above inflation
1990s	2.90%	2.90%	matches
2000-2004	1.15%	2.46%	1.31% below inflation
1960-2004	4.08%	4.24%	.16 below inflation

Looking at the "Rate Comparison" column, we see that in the decade of the 60s savings account interest return was comfortably above the inflation rate, and in the 80s it was slightly above the inflation rate. In the 70s and the first five years of the new century savings account return was uncomfortably below inflation, and in the 90s savings return matched the inflation rate. For the whole forty five years, savings account return was slightly below the inflation rate.

Back to my friend's situation, I said earlier that he was just barely preserving his capital by keeping it in a savings account. Turns out he isn't doing quite that well. He's probably seeing his capital erode slightly in terms of buying power, but when he does retire, he will have that savings, and that's a lot better than having no savings at all.

As we saw in the table above, the inflation rate from 1960 through 2004 averaged 4.24%. How does that influence buying power? Well, the buying power of a 1960 dollar subjected to an average annual inflation rate of 4.24% shrinks to the buying power of 14.23 cents by the end of 2004. To just retain the 1960 buying power of one dollar one would've needed that dollar to grow to $7.03.

To see the effect on buying power of different money management strategies, let's take a look at three scenarios using one 1960 dollar. These illustrations are much simplified for clarity and are hypothetical-as far as I know you can't really start a mutual fund account with only one dollar.

In the first scenario you take your 1960 dollar, put it under your socks in a drawer and vow not to spend it until 2004. The result is that when you haul it out with the intention of buying some fine thing, you find it's power-to-buy shrank to less than fifteen cents because of inflation. Wouldn't even buy you a postage stamp.

In the next scenario you put your one buck into a savings account in 1960 planning to use it for retirement. In 2004 you withdraw the savings account money, put it in your wallet, go shopping only to find the dollar has eroded to buy only eighty six cents worth of merchandise, (two postage stamps plus a little), because the savings account return didn't quite match the inflation rate over the years.

In the third scenario, you invest your 1960 dollar in common stocks and let it ride until 2004. Since stocks historically have returned an average of ten percent per year, you find that your one buck has grown to seventy two dollars and eighty nine cents, which will buy two rolls of stamps with which you can happily mail your retirement announcement to sixty friends and relatives. Your 1960 dollar has grown to exceed the inflation rate by sixty five dollars and eighty six cents.

What conclusions can we draw from this quick look at inflation and opportunity loss?

1. A wise family money manager never buries all his or her money under socks, (maybe a little of it, but not a lot), because inflation will erode buying power in a major way over time.
2. Savings accounts alone will keep up with inflation, but aren't adequate for growing money for future needs. Using savings accounts as a repository for emergency funds and short term needs of other kinds is wise because the money in them will retain its buying power-or very nearly so. Inflation over time is more than a "risk", it is a virtual certainty.
3. The wise family money manager will recognize that fact and take steps to counter the inflation effect.
4. One way to counter the effect of inflation and avoid "opportunity loss" is by making investments that grow money beyond the rate of inflation so as to prepare for long term future needs. This sentence doesn't mean, however, that a person should put their hard earned dollars in highly risky enterprises. There's a much quoted phrase related to investing that says, "if it sounds too good to be true, it probably is."

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