Most of us remember Dr. Arthur Laffer, an economist who worked in the Reagan Administration, and his simple depiction of the relationship between tax rates and revenues. He drew the diagram below (The Laffer Curve) in 1974 on a napkin at dinner. Is there a “Laffer Curve” for investing as well?
In Laffer’s design, tax rates form the vertical axis and revenues the horizontal axis. The idea is that at 0% tax rates and 100% tax rates, the revenues are the same: zero. The question is where is the “sweet spot “ along the curve where revenues are maximized? For investments, we can extrapolate using risk along the vertical axis and return along the horizontal axis. Investments that have 0% risk provide zero return. Extremely high risk investments likely provide almost the same result: zero (or at least near zero) return in many instances. At some point along the risk continuum, we pick up risk much faster than return and this risk becomes counter-productive.
Yes, some “risk” or short term price movement is required in order to obtain investment returns. The reason you receive investment returns is because you accept that “risk.” We don’t encourage trying to precisely pinpoint the exact risk level where returns are “maximized,” but rather, the level where returns are appropriate for you. You always have a choice. You can settle for a small level of risk as long as the accompanying level of return is “enough.” For most investors, however, that is not a realistic option when considering increasing living expenses over time. Our three decades of experience working with successful clients from all walks of life tell us that most investors need to accept at least moderate “risk” to achieve “enough return.” Do you know your “sweet spot”?