Reframing investment risk to make you a better investor
How should risk be considered when planning long-term investments? Let’s better understand the concept of investment risk so that we can use it to react with less emotion and become more successful long-term investors. It's well known that potential loss weighs more heavily on our decision making than does potential gain. This makes sense since we humans evolved to be aware of threats so we could live to see another day.
TLDR at the end of the article.
Why is this important to us?
How would you define investment risk? FINRA defines risk as “any uncertainty with respect to your investments that has the potential to negatively affect your financial welfare.” Investopedia defines risk in “financial terms as the chance that an outcome or investment's actual gains will differ from an expected outcome.” Thomas Howard in his book Behavioral Portfolio Management, defines investment risk as “the chance of underperformance.” Simply put: the uncertainty of whether we will meet our long-term investment objective(s).
Thomas Howard argues that almost no volatility can be explained by changes in underlying economic fundamentals at both the market and individual stock levels. Instead, this volatility is largely caused by crowds overreacting to market and economic information. This means that any metric that uses volatility to describe an investment is more a measure of emotion than risk. To him, volatility and risk are not synonymous and that for our long-term investment decisions, we should eliminate common measures of volatility from our process.
Volatility Metrics
For reference, here are some of the common measures of volatility used by the financial industry.
Possibly the most commonly used measure for volatility/ risk. Think of this as a statistical representation showing how close (or far) values are away from its mean. In essence, it shows how much price deviates from the average price. Large price swings make for higher standard deviations and vice versa.
The problem with standard deviation is that it calculates all uncertainty as risk. For example, price swings to the upside, or above average performance is not calculated separately. In addition, it is based on historical data and we have all seen the “past performance is not a guarantee of future returns” disclaimer.
The Sharpe Ratio takes it one step further. Think of this as a measure of an investment's return compared to its volatility (standard deviation). In theory, it’s an attempt to compare expected returns and the volatility of an investment. For example if you are taking on more volatility, you will want a greater return to compensate you for that volatility.
Since the Sharpe Ratio uses standard deviation as part of its calculation, it suffers from the same drawbacks of volatility assumption and historical data.
How to put this into practice?
To be clear, short term investment goals like an emergency fund or general savings should account for volatility. We want to limit unpredictability or wild price swings for these. There is no need to risk money you may need in the short term.
What if you were asked to help build a retirement portfolio for a family member who plans to retire in 20 years? And I give you two very simplified options:
1. 100% Fixed income/ Bond ETF or
2. 100% Stock ETF
Historically we can expect about a 5% annualized return for fixed income assets and about 10% annualized from the stock market. If your goal is to maximize return then the choice is simple. The 100% stock portfolio will very likely greatly outperform the 100% fixed income portfolio. Over 20 years we can expect our contributions in the 100% stock portfolio to increase by about 6X compared to a 2X for the 100% fixed income portfolio. Even though the average annualized return of the stock market is about twice that of the fixed income (10% compared to 5%) the final returns are about 3X greater due to the power of compounding over 20 years. To illustrate this, a $10k one time contribution would grow to about $67k under the 100% stock portfolio example. Under the 100% fixed income portfolio example our $10k would only grow to about $26k.
Our investment goals should not be undermined by our emotions, and we need to learn to resist temptations to sell in downturns or to add low-volatility investments, which reduce our overall returns. Obviously it can be difficult to watch portfolio values decline during recessions or bear markets, but don't sacrifice long term returns for short term volatility.
There are few guarantees in life and definitely none in investing, but examine your risks within a broader long-term context. Consider inflation, every year the purchasing power of the dollar decreases. Over the last few decades (1990s and 2000s) we have seen historically low interest rates (~2% per year), but this may be changing as we have seen in 2021 and 2022. If for example, inflation ballooned to 8% per year and you were only investing in bond funds that return about 5%, you would be losing purchasing power, which in effect, is losing money. Is this not a risk? Not meeting your long term financial goals is a risk. Not having enough money in retirement is a risk. The irony is that a “safe” investment that has minimal wild swings might help you sleep easy at night, but also causes you to underperform your long-term investment goals.
Since there can be a great deal of variability in returns day to day or year to year, it is helpful to look at rolling returns to better understand longer term performance. For example, no 20 year period during the time frame from 1973 to 2016 has yielded a negative annualized return. The worst 20 year period for the S&P 500, (the 20 years ending in 1979) yielded a 6.4% annualized return. Which, if you compare to our example above, would give you approximately a 3X return on your initial investment over 20 years. Not mind blowing, but still noticeably better than bonds would yield. Conversely, the best 20 year return (the 20 years ending in 2000) delivered an annualized return of 18%. If we plug this into our investment calculator we would find that this would 27X your initial investment. Now that is mind blowing.
Ultimately you need to be comfortable with what you are investing in and if you are not ready to assume a 100% stock portfolio for your long term investment goals, that’s ok. Investing in some stocks is better than none, but make sure you have a solid investment plan. Find what makes you comfortable and work with it. Just remember that the data supports taking the training wheels off and maximizing return.
Sample investment portfolios
Dividend growth portfolio for those looking for battle tested companies that have consistently raised their dividends year after year.
Growth or Value portfolios for those looking to gain stock market exposure in growth or value styles.
Aggressive or Moderate ETF portfolios for those who are not ready to fully commit to an all-stock investment for their long term goals.
TLDR::
Risk and volatility are not always synonymous. When we consider long term investment time frames we should put more focus on what will give the best performance, not what will reduce volatility. Build a strong stock based portfolio with a trusted financial advisor and let it go to work for you.
If you are curious what average returns might look like for various asset allocations (stock/ fixed income), see Vanguard's comparison charts.
If you are curious to see how investments can grow over time you can try this online investment calculator.
