Friday, September 16, 2005


In financial terms, risk means uncertainty of outcome. There is risk when I invest in the stock market, because the value of my investment may go up 50% or it may go down 50%. The upside is the kind of risk I don't mind, while the downside risk is the kind I hate. However, to have a chance at the upside risk, I must accept the possibility of the downside risk.

I am looking at my annual Social Security statement, which estimates my future benefits when I reach retirement age in 30 years. With the help of an Excel spreadsheet I determined that, if nothing changes, the effective rate of return I am getting over those 30 years is 1%. In other words, I would do just as well to put the money in the bank earning 1% and withdraw it when I retire. One dollar paid in social security payroll tax today translates into $1.35 in 2036. Assuming that inflation continues at an average rate, that $1 in today's money will buy 42 cents worth of groceries in 2036. This is the upside of social security. For every dollar they take today, I get back 42 cents in todays money thirty years from now. If that is the upside, what could the downside be? They have already told us that they can't keep the current system in place forever. Before I retire they will either have to cut the benefits or increase the tax. Or both. The downside is that Congress may decide, any time in the next thirty years, that 42 cents on the dollar is too much, and they will only give me 30 cents. Or 20. Or nothing at all. This "safe, secure" retirement program is not only subject to purchasing power risk, it is also subject to Congress risk -- the risk that Congress won't be able to keep their hands off of that money. This is a very real risk, because Congress has a very hard time keeping their hands off of any money.

If the upside of social security is a 58% real loss, and the downside is a 100% loss, how does that compare to the "risky" stock market?

The average real return of the stock market over a 130-year period from 1870 to present was 6.3%. At that rate, one dollar invested for 30 years would grow to $6.25 (all figures are in today's dollars). The upside is that in some periods the stock market returned as much as 8.8% over 30 years, meaning that our dollar would be worth $12.57, or double the average amount. The downside is that in other 30 year periods the real return of the stock market was only 4.3%. Our dollar would have only grown to $3.54.

The best case for social security: we lose half
The worst case for the stock market: we triple our money

So the worst case for the stock market is six times better than the best case for social security.

You tell me which one is risky.

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