Here’s a trick question, see if you can figure it out. Of the following two investments, which one carries the lowest risk — cash or stocks?
You might be tempted these days to blurt out “Stocks, of course!” Valuations certainly seem rich about now. Earnings are downbeat. Nobody seems to know what’s next with the economy, employment, interest rates and so on.
The answer: Cash, hands down.
None other than billionaire investor Warren Buffett addressed this concept in his most recent letter to the shareholders of his company, Berkshire Hathaway.
Many retirement investors, he said, tend to think that cash is safe and that stocks are risky. Many would put cash in their mattresses over buying equity in a public company.
But it really should be other way around. Stocks have a long-running record of handily outperforming the major investment choices, including gold and bonds.
But it’s cash that is the absolute loser, thanks to inflation, a relentless force that destroys purchasing power like rust gnawing away at an unpainted bridge.
As Buffett explains, during the five decades from 1964 through 2014 the S&P 500 Index returned 11,196%, including reinvested dividends. During those years, the value of a dollar fell by 87%.
If you owned U.S. bonds during those years, yes, you earned a “safe” rate of return, but you ultimately lost 87% of the purchasing power of those invested dollars.
The problem, Buffett notes, is that people equate volatility — the daily movement of stock prices up and down — with risk.
In business schools, volatility is almost universally used as a proxy for risk, Buffett warns. “Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray,” Buffett told his investors.
But what is risk, really? From the perspective of the experienced, long-term investor, risk is not about fluctuations in the prices of stocks. Rather, risk is defined as a permanent loss of capital.
By definition, then, inflation is risk, a permanent loss of capital. You cannot reverse inflation. You can only attempt to outrun it.
What outruns inflation? Well, stocks do. Jeremy Siegel, the Wharton professor who wrote the investment classic Stocks for the Long Run, calculated the long-term return on stocks at 6.6% (including reinvested dividends) after inflation is factored in, known as “real” return. That was from 1802 through 2012.
Bonds, comparatively, returned 3.6% after inflation. For gold, the real return was just 0.7%. The dollar lost ground, naturally.
Let’s try this another way. What’s the better investment, money in a savings account or investing into your own business? “Well, duh, my own business!” you might say.
Of course it is. You know perfectly well how to make your business run profitably. All things being equal, that’s the obvious choice.
Are you better at it than 90% of the S&P 500? The heads of Toyota, Nestlé or Apple? Do you have some secret to growing money that eludes the folks in charge of IBM? ExxonMobil?
Nope, you don’t. They are pretty good at making money, too, and when you own stocks you own a piece of that growth, plus the dividends you plow back into your holdings, year after year.
Buying publicly traded stock is not risk-free, but avoiding stocks for the “safety” of cash is a mirage, and a dangerous one for your retirement to be sure.