- 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 – 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. Now, return varies with the category of investment – see below:
Average rate of return
Bank account 2%
Government bond 3.5%
Corporate bond 5.5%
REIT (real estate) 8%
S&P 500 10%
Nasdaq 100 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 – 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 be you one day), higher average return comes with greater uncertainty / risk of year-to-year return.
Question: 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.