The Time Bomb in Your Portfolio

Investing is risky. Everyone knows that. There are no guarantees. But the biggest risk to your portfolio isn't what you think it is.

The concept of risk, you see, means different things to different people. Moreover, if you asked an academic about risk and how to minimize it, most of the answers you'd hear would be unhelpful when it comes to the real world of investing.

Even worse, none of those answers would help you defuse the biggest risk to your portfolio.

Can't go back
The most quoted measure of risk is beta -- actually a measure of volatility. The general thinking is that a stock that jumps around a lot is riskier than a stock that doesn't because the volatile stock's returns will deviate substantially from the market average.

Hogwash! Risk and volatility don't equate. I couldn't care a lick about whether or not a stock's returns deviate from the market average as long as those returns are better than the market average. For example, I know I wouldn't object to having owned these volatile (beta greater than 2) stocks over the past year:

After all, there's an easy way to take the volatility out of a volatile stock: Don't check the price.

I don't want no hippie pad
But the conception that volatility and risk equate is so ingrained in the world of financial planning that too many investors, fearing volatility, have stashed far too much of their savings in CDs, Treasuries, and bonds.

Because the real risk when it comes to investing is not volatility. Rather, as master money manager Ron Muhlenkamp often notes, risk is "the probability of losing purchasing power over time." Consider this: If you're not earning at least a 3% annual return after taxes, your money is losing value.

Your goal in investing, then -- if you'll forgive me for putting words in your mouth -- is not simply to increase your savings, but rather to beat both inflation and cost-of-living increases to increase the purchasing power of your savings over time. That means that if inflation is 3% annually and housing prices rise 3% annually, you need to be making at least 6% to stay on track to buy that vacation home in 10 years. And if you're hoping that your investments will help you afford the vacation home, you need to be earning a good bit more than 6% per year.

In other words, you need stocks.

Milo goes to college
But don't take my word for it. Mr. Muhlenkamp actually has data to back up this conclusion. He found that, from 1952 to 2002, stocks returned 11.2% annually. That's 7 percentage points better than inflation and resulted in a 33-fold increase in purchasing power.

Bonds, on the other hand, returned 6.8% per year. That's just 3 points better than inflation and yielded merely four times the purchasing power.

And to prove once and for all that risk and volatility don't equate, Muhlenkamp found that during that 50-year period, bonds had 16 down years, while stocks had just 13.

Better returns, fewer down years, substantial increases in purchasing power -- you need stocks.

Cool to be you
The time bomb in your portfolio is inflation, and you need stocks to make sure it doesn't do you in. Any money you don't need for at least three years should be invested in stocks. And not just any stocks, but stocks that will outperform the market average. Otherwise, your seemingly low-risk portfolio may cause you to lose significant purchasing power over time.

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This article was first published on May 3, 2007. It has been updated.

Tim Hanson does not own shares of any company mentioned. Talk to your children about the Fool's disclosure policy. It may be the most important decision you ever make.