Chris Farrell: Rewiring the risk and reward equation for better sleeping

Q: Investment advisers often tell you to only invest in stocks an amount that allows you to sleep comfortably at night. My problem is a Catch-22. One is that if I reduce my exposure to stocks to where I can sleep comfortably at night, then I can’t sleep because I feel like I am not earning enough on my total investments to allow me to retire comfortably.

I am 53 and am putting away as much as I can, but will need a decent return to try to retire in 10 years.

Jeff

A: The stock market put on a blockbuster performance in 2013 with total return (including dividends) for the S&P 500 at 32.4 percent. Of course, recent past performance doesn’t tell us what comes next.

A basic relationship informing modern finance is the proposition that returns are only earned as compensation for taking on risk. A classic example: Stocks are riskier than bonds since equities represent the uncertain rewards for entrepreneurship, while bonds are long-term contracts that spell out when borrowers must make principal and interest payments.

“There is no predestined rate of return, only an expected one that may not be realized,” wrote Laurence Siegel when he was director of investment policy research at the Ford Foundation. “The risk of holding stocks, then, is the possibility that in the long run, returns will be terrible.”

What to do? Recall the lesson of the Kobayashi-Maru. For those who aren’t “Star Trek” fans, it’s the name of a famous Starfleet Academy test. The computer simulation is designed to be a no-win situation. Cadets are judged on how they deal with that realization. But one cadet beat the simulation — James Kirk — by changing the rules of the game. Kirk hacked into the academy’s computer and reprogrammed it so that he could win. Kirk was rewarded for his ingenuity.

You can’t rewrite the code for the risk-and-reward trade-off with equities. But you can still change the rules of the retirement game by shifting the focus of your long-term planning, starting at a different place. For example, put aside thoughts of equities for the moment. Think instead about your education, your job, your career — what economists call your “human capital.” You mentioned you might want to keep working in the traditional retirement years, but fewer hours. Good idea, since the income you’ll earn from part-time work will dwarf the sums you’ll get from your investment portfolio.

Question is, what kind of work? Do you have the skills you need? Can your network help you get that work? What investments can you make to boost the odds of a decent paying part-time job?

Another possibility: Embrace frugality. We all know that for too long many of us have equated the good life with owning lots of stuff. But those things that deliver genuine returns include experiences, creativity, ties of family and community. Frugality isn’t cheapness. Far from it. The frugal approach seeks out quality, not quantity. On the financial front, frugality ends up creating both greater spending satisfaction and a financial margin of safety.

So, by all means invest in equities to the sleeping point. But shore up your long-term financial security by taking a different approach: human capital, frugality, a combination of the two or some other mix. It’s a stronger foundation than relying on fickle equities. You’ll sleep better, too.

Chris Farrell is economics editor for “Marketplace Money.” His e-mail is cfarrell@mpr.org.

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