A friend and I were discussing our respective investment approaches this week. He is happy with having a lot of cash in safe investments such as CDs and money market funds earning around 5%, a position with which I agree. He also holds marketable securities for which he is hoping for a 5% return this year. Many prognosticators are looking for similar market returns in this up and down year.
But think about that for a moment. If risk-free money is earning 5%, that means that any investment return with risk attached should be earning enough to compensate for the risk. Now the question: Is 0% adequate compensation for the risk of holding stocks with fluctuating valuations that are a bit high by historical standards? Clearly the answer is no. It’s reasonable to expect at least a 10% or more additional return for taking on risk, just as when you own a business. And the riskier the investment or the business, the greater should be the risk premium over safety.
So what should my friend (and I, in full disclosure) be doing with that money that is at risk but not likely to earn anything additional in return for taking that risk?
- Sell the stocks and move the cash to money market funds, hoping there will be a clear sign when to move it back again, as interest rates are about to decline and market valuations are about to move up again? Hah! Good luck with that bit of crystal balling.
- Sell the stocks and move the money into CDs and hope we guessed the right maturity for those CDs so that we will be able to convert them back into stocks when the market is about to turn up? Well, at least in this case you only need one crystal ball instead of two.
- Adjust our portfolios to remove the riskier holdings and add to the more solid companies that are most likely to grow faster than the general market when the interest rate/inflation thing settles down? Probably a sensible strategy except for the crystal ball thing again.
- Sit tight, trust our earlier judgments, and recognize that some of our holdings will do better than others, some will get sold along the way, and opportunities to add others will arise as well? For better or worse, that is the strategy I’ve taken, although I’m not sure what my friend plans to do.
Every action has consequences. What do you think? What would you do? What are you doing? We welcome your comments and thoughts. And despite the distinctly personal nature of this post,
…we are still your CFO for Rent.