Thursday, August 30, 2007

The Extremes of Investing

A few days ago I wrote a post about a friend of mine that picks stocks and tries to buy shares during IPOs. Today I would like to write about one of my colleagues, who takes the exact opposite approach.

Late last night I returned from a business trip to several mid-western cities. Accompanying me on this trip was a good friend and colleague. Our trip involved a lot of driving around and so we had a lot of time to chat. If you are going to spend much time with a personal finance blogger, the conversation will eventually work its way towards the topic of personal finance. It's the nature of the beast. During one of these long drives I was commenting to my friend about the extreme volatility we have been seeing in the market in recent days, I also commented on the fact that I think that the U.S. economy is headed towards a recession. My friend very calmly responded that he is not concerned about the stock market, because his entire portfolio is invested in cash. Then, completely disregarding my incredulous stare, he proceeded to encourage me to follow the same strategy. I think I will stick with a more sane asset allocation.

My colleague is about 15 years older than I am, in his very early fifties. He is a well compensated professional at the top of his career, however, he still has many years to go before retirement, which is why I was very puzzled by his investment strategy (or lack thereof). When I asked him about it he simply said that he is very risk averse, and following this ultra-conservative strategy allows him to sleep peacefully at night.

I have previously commented about the need to understand your true level of risk tolerance. Going above this level is a sure fire way to make stupid investment decisions, such as selling at the worst possible time. However, I think that my friend's complete lack of tolerance for risk is the riskiest strategy of all. With the meager returns you can generate in the money market or by buying CDs, you would need to be a truly copious saver to sock away enough money to allow for a comfortable retirement. I think my friend is suffering from a particularly nasty strain of the fear of investing disease.

As a final comment, I would like add that even though I think that we are on our way to a recession, I am holding on to our stock positions and will continue to do so. There are two main reasons for this. First, selling my stock portfolio would immediately trigger a massive capital gains tax liability. I may lose money by staying in the market, but I am guaranteed to lose money to greedy Uncle Sam if I bail. Second, while I think that we are headed for tough economic times, I do not have a crystal ball - let me tell you a secret, neither does anyone else. So while I trust my intuition and my training, I never try to out-guess the collective wisdom of hundreds of millions of investors. I may be smart, but I am not THAT smart. Very few people are.


Chief Family Officer said...

Wow! I had to read that sentence about cash twice because I couldn't believe it the first time! I hope that the cash is at least invested in accounts that earn more than the rate of inflation.

Shadox said...

The REALLY crazy thing is that he thinks that he is being extremely prudent and smart about this strategy.