- In the sphere of finance, it is said that “there is no free lunch”. The meaning of this expression is that higher return must be paid for by accepting higher risk.
- In prior discussions, we have examined the behavioral concepts of loss aversion, savings as a loss, inertia, present self versus future self â€“ these are some of the behavioral traits that discourage saving for the future.
- But suppose we overcome all these behavioral barriers to savings, we then need to decide what to invest in.Â Now, return varies with the category of investment â€“ see below:
Average rate of return
Bank accountÂ Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 2%
Government bondÂ Â Â Â Â Â Â 3.5%
CorporateÂ bondÂ Â Â Â Â Â Â Â 5.5%
REIT (real estate)Â Â Â Â Â Â Â Â 8%
S&P 500Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 10%
Nasdaq 100Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 15%
- The plot below gives the outcome of investing $200/month ($2,400 per year) for 40 years in the respective index fund:
- If all were of equal risk, then obviously we should choose the Nasdaq 100 and obtain 15% returns. But the reality is that return reflects risk â€“ see the plot below of the Nasdaq 100 index (pink top line), S&P 500 index (blue middle line) and bond index (green bottom line):
- In finance, we equate higher risk with higher volatility / movement of the asset price, so the Nasdaq 100 is considered the riskiest under standard theory. To see this, consider a pensioner who lives off of the return from their investment account; with the Nasdaq 100, their returns are in the range +/- 30%; with the S&P 500 they are in the range +/- 20%; and with the bond fund they are almost constant (reflecting constant coupon payments). Thus, for the pensioner (this will beÂ youÂ one day), higher average return comes with greater uncertainty / risk of year-to-year return.
Question:Â looking at the above plots, which of the three index funds would you prefer to invest in over the next 40 years, for your long-term retirement account. Explain your choice, considering (a) your personal ability to tolerate risk and (b) your goal for retirement lifestyle.
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