Most investors think about risk completely wrong. They focus on volatility but don't consider their holding period. As an investment industry we tend to look at a statistical metric called standard deviation. That measures how much volatility you can expect with a specific data set. The problem is that standard deviation is almost always quoted over a one-year period. But what investor has a holding period of one year? In reality, most people are investing for 10, 20 or 30 plus years. What should matter to them is not what volatility their portfolio could experience over one year, but over their entire investing holding period. Investors only realize losses after they sell. If they don't have to sell, no losses have actually been realized. As we have often said, there are really only two days that matter when you invest…the day you buy and the day you sell. Everything in between is just noise. As long as that noise doesn't scare you into selling, you can disregard the ups and downs of the market day-to-day, year-to-year.
How can I say this confidently? I know what the data says. First, let's look at risk and return statistics of the US Stock Market (CRSP 1-10 Index) from 1926 through September 2015:
- Average annual return: 12.07%
- Standard deviation: 21.20%
What that standard deviation statistic tells us is that over 1 year periods we can expect the following probabilities:
- 66% of the time we can expect returns to be between 33.27% and -9.13%.
- 95% of the time we can expect returns to be between 54.47% and -30.33%
- 99% of the time we can expect returns to be between 75.67% and -50.53%
No wonder people think stocks can be risky. Losses can be pretty common and losing a third of your wealth is just something you will probably need to accept at least once or twice in your investing career. But remember, these are stats over 1 year. How many of you are selling all your investments within the next year? Probably not many. More likely you need your money to last for decades. So when we look at risk, shouldn't we be looking over your time horizon, not over some arbitrary period like one year?
I re-ran the statistics but instead of 1 year returns, I looked at 20 year returns (annualized):
- Average annual return: 11.03%
- Standard deviation: 3.18%
These statistics tell us that over 20 year periods, we can expect the following probabilities:
- 66% of the time we can expect returns to be between 14.21% and 7.85%.
- 95% of the time we can expect returns to be between 17.39% and 4.67%
- 99% of the time we can expect returns to be between 20.57% and 1.49%
Looking at this data should shift your entire way of thinking about risk. Stocks really aren't that risky if you can hold them for 20+ years. In fact, when you look at them over longer time periods, they are even safer than bonds. For example, Long-Term Government bonds have a standard deviation of 3.51% over rolling 20 years (compared to 3.18% for stocks) and their average 20 year return has been 5.56%, about half that of stocks.
This is why most people should be holding a decent portion of their portfolio in stocks. As long as they can stomach the year-to-year volatility, their actual risk is quite low when you extend out their holding period.
*Data take from DFA Returns 2.0 Program
Much has been written about disability insurance. This blog post, instead of discussing the merits of disability insurance in general, will focus on one concept that could potentially save you 30%-40% in premium costs annually – the elimination period. The elimination period is the amount of time, after sustaining a disability, that someone must wait before the insurance company begins payments. Auto and home insurance have deductibles before they start paying out claims. Disability insurance (and long-term care insurance) has elimination periods before paying out claims.
One of the most common elimination periods is 90 days. Because insurance companies are more likely to make payouts with a 90-day policy, the costs are much higher. For those who can easily afford the higher payments and who want to minimize the risk to a very low level, this could be a good decision. But for most of us, this is not the best way to think about insurance. We believe that insurance should protect you from catastrophic risks. Self-insurance for smaller claims is often the more efficient way of handling those risks.
Rather than automatically selecting the 90-day elimination period, you should consider the 365-day option instead. In many cases, the true risk to a long-term financial plan is not one year of lost income. It is 5, 10, 20+ years of lost income. Let’s take someone with a 10 year disability. He/she would receive 9 years of payments with a 1 year elimination period and 9.75 years of payments with a 90-day elimination. In essence, this person receives over 92% of the benefits (9 years divided by 9.75) while likely paying only 60-70% of the premium (of what a traditional 90-day elimination period policy would cost). Of course, you have to be willing to forgo benefits if you experience a shorter-term disability (lasting less than 1 year). This is accomplished by keeping an adequate reserve fund (cash or highly liquid safer investments) available to cover one year of expenses should you become disabled. By utilizing a longer elimination period, individuals can protect against devastating losses, while keeping their ongoing premiums affordable.
As always, individual situations and policies vary so it’s best to speak with someone objective about these issues. Insurance agents, many of whom are compensated with a commission based on the cost, often do not highlight these longer elimination periods. So make sure to ask questions, get the facts, and make the best decision for you and your family!
Several days ago there was an 8 car pileup in Hunt Valley, Maryland, the town right up the street from us. While there were no fatalities, this is the type of event that could completely derail a client's financial plan. Let me explain. We often tell clients that a plan that requires everything to go right is not really a plan. It is more like a dream. Bad things happen in life. At Greenspring, when we bring on a new client, we try to consider all of the bad things that could occur which would prevent our client from achieving their goals. A disability that prevents you from working, a lawsuit against your company, employee theft, a premature death of one or both spouses are just a few of the events we might consider when strategizing about this topic. To take it a step further, understanding what risks should be transferred (to an insurance company) and what can be retained (via self-insurance) is an important point to understand. It makes no sense for someone who has $100,000 of cash reserves to have a very small deductible on the car or home policy. They can self-insurance the loss up to some amount, creating lower premiums and less chance of frivolous claims. Conversely, a parent having too little disability insurance could totally wipe a family out (due to lost wages and higher medical costs) if that disability were to come to fruition. There are no rules of thumb when it comes to risk management. Each situation is unique, but everyone must think through the framework of "what losses can I live with and what losses would bankrupt me". That is the starting point to develop a risk management plan.
Getting back to the article I quoted in the story. I don't know the extent of the injuries or damages to vehicles, but an 8 care pileup could easily cause $500,000 of liability or more for the person responsible. With most standard auto policies capping out at $250,000 or $300,000 this is one of those things you would hope the driver thought of and insured against appropriately.
Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.