Conventional investing wisdom often conflates volatility with risk. In that view of the world, part of the reason stocks are riskier than bonds is because stock prices typically wiggle up and down more than bond prices do.
Silly, yes, but it's one of the reasons why people mistakenly think of "cash" as a risk-free asset -- since a dollar is and will always be worth exactly 100 cents. Because its face price never fluctuates, it is about the least volatile asset out there.
But it is still risky
The problem, though, is that while cash isn't volatile, it is really a risky asset to hold. It's risky because its purchasing power falls virtually every year, thanks to inflation. According to official statistics, inflation ran at 3.6% over the past 12 months. With rates on bank money market accounts averaging around 0.7%, the typical cash holding is losing ground to inflation, even before taxes. Take out marginal income tax rates from that anemic income, and it just gets uglier.
If you hold on to cash too long in an inflationary environment, it becomes worth less and less from the perspective of what you can buy with it. That may not be "risk" in the volatility sense of the word, but unless you've figured out a way to eat without buying food or fill your fuel tank without buying gasoline, it's a risk to your lifestyle nevertheless.
Think long term
Over a lifetime of investing, the daily volatility of the market's ups and downs is washed away by the power of time. On that scale, individual stocks are still risky, as companies do fail, but the fate of the stock market as a whole is tied to the overall economy rather than to individual businesses. As long as economic cycles mean that boom follows bust and growth triumphs over time, in the long run, stocks, with all their volatility, can actually be less risky than cash.
For that to really be the case, though, it's not just enough to merely buy stocks and hope for solid returns, especially if you need to pull some income from your investments. Instead, you need to build your portfolio around three key, fundamental principles designed to provide you with an income stream with the legitimate chance to at least keep pace with inflation.
How do you do that?
The three key principles are:
- Diversify across industries: If the recent financial meltdown taught us anything, it's that entire industries can still go down together. After all, the number of banks driven to failure by that crisis runs well into the hundreds. By owning stocks in multiple industries, you protect yourself from being destroyed by the next such debacle.
- Insist on financial strength: A debt-to-equity ratio below two generally indicates that the company hasn't overleveraged itself. Similarly, a payout ratio below two-thirds of earnings means the company holds on to enough cash to sustain the business behind its dividends.
- Look for a history of rewarding shareholders: Although past performance is no guarantee of future success, a company that has consistently raised its dividends is far more likely to continue doing so than one that has never paid its owners a dime.
When trying to build a portfolio based on those principles, there's good news and bad news. The bad news is that it does limit the number of companies that pass muster. The good news, though, is that those that do meet these tight criteria tend to be well-established, proven industry leaders with clear staying power and track records of directly rewarding their shareholders. In effect, you wind up with companies like these:
Lowest Dividend Growth Rate in Last 5 Years
Source: Capital IQ, a division of Standard & Poor's.
Balance your risks
With dividend yields well above current money market rates, you get more income owning these stocks than holding cash. With dividends that have increased at decent clips, you also get a better chance of your income keeping up with inflation. It's a great contrast to the guaranteed long-term loss over time to holding cash whose income stream is not keeping up with inflation.
What you don't get, though, is a completely risk-free portfolio. You do pick up the volatility risks of owning stocks, though that's less of an issue if you don't need to sell. And of course, stocks each represent individual businesses, and those businesses can fail. That's why it's important to look for financial strength, direct shareholder rewards, and diversification. Because while you can't completely rid yourself of investment risk, those characteristics can help you reduce it.
Ultimately, your money is at risk, whether you're holding cash, stocks, or any other asset. Managing that total risk picture is a critical part of your long-term financial success.
At the time of publication, Fool contributor Chuck Saletta did not own shares of any company mentioned in this article. The Motley Fool owns shares of Coca-Cola and Abbott Labs. Motley Fool newsletter services have recommended buying shares of Linear Technology, Abbott Labs, and Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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