Let’s rap about risk. I have a zero-tolerance policy for risking my client’s money. Now, that doesn’t mean clients should never risk money. It just means any money my clients give me is not at risk in the financial markets.
This wayward financial advice hinges on a financial concept called “risk capacity.” Risk capacity refers to how much risk you must take in order to meet your financial goals. Or, more accurately, it’s the amount of money you can afford to risk or lose. Most financial advisors use risk tolerance when making investing recommendations because risk capacity would be a senseless way to approach investing. All your money is at risk in equity investments.
Risk tolerance refers to how you feel about risk. As long as you feel OK about taking risks on paper, investments are suitable. But… this doesn’t really capture what you can afford to lose while still meeting your financial goals. It just measures how you feel about taking the risks you’re taking.
If you can afford to meet all the important future financial goals in your life with the savings you have, you have a high capacity for risk. If you cannot afford any of your important future financial goals, your risk capacity is essentially zero. If you can afford some of your financial goals and not others, you can some risk capacity.
This approach is totally lost on folks who only push an investment-driven approach to financial planning. Since investments aren’t guaranteed, you must rely on hypothetical returns and investment positions which you can lose.
In other words, you have to build your financial plan on speculation.
In my weird way of thinking, this is a bad idea.
Toward the end of the 1930s, the personal savings rate started to rise, and then spiked in the ‘40s to 15%. This was the “golden age” of saving, and most people used whole life insurance and bank savings accounts as their primary savings vehicles. Whole life insurance was particularly attractive due to the forced savings aspect of the contract and the dividends life insurers paid on the policy in addition to the guaranteed cash value growth.
In 1976, the savings rate peaked at 14%, and then… something weird happened. The 401(k) plan was mainstreamed and people were told they could be investors… the A.L. Williams corporation (which exclusively sold term life insurance) started telling people whole life insurance was a rippoff and convinced millions of people to cash in their whole life policies for term insurance. Williams sold expensive term insurance, but since the premiums were lower than whole life insurance (which includes both insurance AND savings) it looked like a better deal than whole life. He then put his clients “savings” into annuities and mutual funds and projected very high rates of return on that savings.
To compound the problem, credit card interest was tax deductible until 1986, which encouraged people to 1) rely on high stock market returns and 2) spend as much as they could on tax-deductible credit cards because tax deductions are awesome.
Savings rates plummeted.
People relied more and more on high investment returns and less and less on a high savings rate.
Today things are starting to move in the opposite direction, but speculating on stocks and investing in 401(k) plans is still insanely popular and so we see savings rates bounce back and forth. When the stock market does well, savings rates go down. When it crashes, savings rates spike.
There could be lots of reasons for this, but methinx a major reason is people undersave when they believe they will make a lot of money in the stock market. And, when returns are conservative and stable, they save more and, generally speaking, tend to be more “financially aware” and stable.
But it’s not just individuals.
Pensions had and still have the same exact problem as individual investors. Most pensions banked on a 7.75% rate of return on stocks and… never got it. So, as a result, the plan ended up being underfunded. A higher contribution rate to the pension was considered “expensive” and so not very palatable to employees because it would mean lower paychecks.
And there you have it.
Savings is the problem and also the solution.