You Are Thinking About Risk All Wrong

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

The Riskiest Day Of Your Life

There is one day among all others that it is the riskiest day of your financial life.  The day that you retire.  Let me explain.  There are two main risks when it comes to investing.  First, the most obvious risk is volatility.  The chance of loss that can occur, especially when you invest in risky assets like stocks.  The second risk is inflation, or the potential for outliving your money.  If the costs of goods and services go up faster than your investment portfolio this becomes a real risk. These two risks are elevated the day your retire.  If you experience a major loss in your portfolio in the first year of retirement, you are going to have to maintain your lifestyle on a much lower asset base for the next 25+ years.  Similarly, if inflation explodes higher right after you retire, you will need to generate more income for your entire retirement just to maintain your current standard of living.

To look at it another way, if you are 90 years old, both volatility and inflation aren't as large of a threat.  You just aren't going to live that long for those risks to do significant damage.  If I am 92 years old, have $1 million, and am pulling $50,000 per year from the portfolio, it really doesn't matter that much if I lose 30% of the portfolio value,  I still have 14 years of income ($700,000 portfolio divided by $50,000 per year) left if the portfolio has no growth from that point on.  These risks subside every day as your life expectancy gets shorter.

At retirement, there are some ways to mitigate those risks:

  1. Volatility- there are two ways to counteract volatility.  The first, and easiest.  Invest in safe assets.  If you just buy CDs with your money you won't experience any volatility (unfortunately you won't earn much either).  Another way to reduce volatility is to extend your holding period.  Over rolling one year periods, stocks lose value about 30% of the time.  Over rolling ten year periods, they only lose value about 5% of the time (S&P 500).  That is why volatility is not a major risk to younger investors.  If they don't sell, those losses tend to recover, because they have lots of time before they need their money.
  2. Inflation- while we haven't seen any significant inflation in our country since the 1970s and early 1980s, it would be wise not to disregard this risk.  One of the best ways to fight inflation are with assets that benefit from rising prices.  Mainly, stocks have been able to incorporate rising inflation into the prices of the products they sell and real estate increases rent and sees values go up.  More recently, the US government has created inflation protected securities which increase in value directly with the consumer price index.  In short, there are specific securities that can help combat an inflationary environment.

Thinking about these risks and how to mitigate them in retirement is key to a successful retirement income strategy.  Now that pensions have become less common, and interest on CDs and bonds are meager, it is more important than ever to have a solid strategy in place.

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.