Talk about portfolio growth rates for long enough and people start to glaze over.  Numbers get compartmentalized, and the concept of risk gets hazy.  After all, if you’re a long term investor you can afford to have have a high risk tolerance, right?  Common advice is that if you hold onto your investments long enough, you’re virtually guaranteed a good return.

Like most things in popular finance, I believe that’s a gross over-simplification.  So let’s look at a savings and investing example in real-life terms — saving for a college fund.  Let’s assume that a proud new parent named Sarah wants to put away enough money each year to save $100k in today’s dollars in 20 years (the absolute amount will be much higher than that due to inflation).  How much should she save, and how should she invest the money?

Sarah is good with money and already understands a bit about investments.  She’s read many places that the average real return for the stock market is great over the long term, and with 20 years to wait out any dips she’s comfortable with volatility along the way.  She fires up her trusty spreadsheet, and concludes that saving $2000 a year (increased by inflation each year) and investing it all in a total stock index fund like VTSMX will get her there.  It’s a reasonable and responsible plan.

Let’s use the Hurricane calculator to see how her college fund would have looked 20 years later depending on when her child was born.  I’ve highlighted the key data in green.

The median inflation-adjusted portfolio value after 20 years is indeed $101k.  The plan was a success, right?

Did I mention Sarah’s child was born in 1989?

Someone who started saving in 1989 woke up 20 years later with a college fund of only $51k.  She missed her goal by half!  Unable to come up with a $50k shortfall, Sarah and her child are faced with the decision of signing up for debilitating student loan debt or foregoing college altogether.  In the end, the risk was not that the portfolio may be volatile at times.  The true risk was that her child’s life would be forever affected by a financial plan with high uncertainty.

Risk is measured in life goals, not in standard deviations.

As a side note, don’t fall into the trap of thinking that the down year was probably an outlier that can be safely ignored.  Note that the chart is color coded by start year.  Those light pink recent years are all trending to the low side.  Sarah’s problem is your problem!

So what is a caring mother to do?  When planning for a future financial goal, it is helpful to consider not only the average investment return, but also the uncertainty.  Returning to the Hurricane calculator, we can play around with asset allocation and annual contribution to look for alternative savings methods.  Here’s how the same goal might be achieved with the Permanent Portfolio.

The Permanent Portfolio has a bit lower average returns than the stock market alone, so you need to save $3000 a year instead of $2000 to reach the same median goal of $100k.  But the worst case scenario was that the college fund ended with $93k (considerably better than the total stock market even with the same savings increase), and Sarah felt like $7k would be easy to scrounge up if necessary.  Saving an extra thousand dollars a year is certainly not effortless and takes resolve, but it sure is a lot easier to do than looking for fifty thousand at the last minute. The return on that extra savings over the years is the peace of mind that the plan is far more dependable.  For a college fund that may be a more suitable plan for a lot of people than saving the minimum, increasing the investment volatility to compensate, and hoping for the best.

When you think about investing risk, don’t just look at the average numbers or assume that time is always on your side.  Think about what the very real downside risk will mean to your important time-sensitive life goals.  Live in the real world, understand uncertainty, and plan accordingly.