Understanding Risk ...as Critical when Investing as when Flying (Part 1)
Updated: Jan 18, 2022
If we didn’t accept some risk in military flying, we would never even take the aircraft airborne. That's not only true of flying, but any military operation. Similarly, in investing, some type of risk is inherent in the activity. The key is to understand the types of risks and your risk tolerance.
Part 1 of this blog examines how investing in too risky of a portfolio hurts your odds of success. Part 2 examines how investing in too safe of the portfolio may also reduce your odds of success. For purposes of this discussion, we’ll define portfolio risk as to the standard deviation of average real annual returns.*1 We will assume we are discussing diversified portfolios and therefore not addressing unsystematic risks that can be diversified away.
There are two main ways that investors often invest in too risky of a portfolio. First, they may invest in a portfolio that will be too volatile for their comfort level. If they do, they are more likely to sell when the market declines. Selling in downturns can be a significant problem as the returns earned by the average investor are at least two percentage points lower than the average return rate because the money tends to come in at or near the top and out near the bottom.*2 Second, they invest in a risky (equity) portfolio for a shorter-term holding period.
First, we'll examine what probably when an investor picks a portfolio that's too risky for thier comfort level. The stock market is volatile and it pays to keep a buy and hold strategy. Figure 1 shows the performance of the MSCI World Index, which is one broad measure of global equity returns from 1970-2020.*3 Note, there are numerous significant drops in the equity index, but over time, the index recovers from those drops during this period. However, if an investor sells during the falls, they will not capture the index's return.
Figure 1. Markets have rewarded long-term discipline.
The following graph in Figure 2 also depicts how important it is to stay invested in capturing long-term equity returns. The chart shows what would have happened to $1,000 if it was put into the S&P 500 index from 1991-2020.3 If the index were held for the entire period, the $1,000 would have earned a 10.23% average rate of return and grown to $20,451.3 However, missing out on even a few of the market’s best days can have a significant impact on cumulative returns. For example, missing out on the five best days would have resulted in an average return of $8.6%, and the $1,000 would have only grown to $12,917. So how can an investor be sure they’re not going to miss out on the best days? The best way is to hold the index the entire time. Holding the whole time resulted in an ending value 63% higher than missing out on the five best days. That’s very significant difference in ending values.*3
Figure 2. Average of S&P 500 Index as best days are missed.
While investing in a portfolio that is too volatile decreases your chance of meeting your goals, so can investing in stocks when one has a shorter-term holding period. Wharton School of Business Professor Jeremy Siegal explains that while stocks are more volatile in the shorter terms, for longer-terms, stocks can even be less volatile than bonds. He depicts this concept in Figure 3 below which shows the standard deviation of average real stock, bond, and bill returns over various holding periods between 1802–2012.*1 Note that over the 30-year period, the standard deviation of the returns on the equity portfolio falls to less than three-fourths that of bonds or bills.*1 So stock returns are very risky for short-term holding periods, but may be less risky than bonds for longer terms.
Figure 3. The standard deviation of average real stock, bond, and bill returns over various holding periods.*1
Part 1 of this blog explains how choosing a portfolio that is too risky (volatile) can hurt returns. First, returns are hurt when investors grow uncomfortable during market downturns and sell at low prices. Second, stocks are quick risky for short-term holding periods but are less risky than bonds for longer-term holding periods. In part 2, we’ll examine how choosing a portfolio that is safer than you need can also reduce the odds of meeting your financial goals.
Footnotes:
1. Jeremy Siegal, Stocks for the Long Run: the Definitive Guide to Financial Market Returns and Long-Term Investment Strategies (New York, McGraw-Hill Education, 2014.)
hypothetical portfolio fully divested its holdings at the end of the day before the missed best consecutive days, held cash for the missed best consecutive days, and reinvested the entire portfolio in the S&P 500 at the end of the missed days.
2. Ilia D. Dichev, “What are Stock Investors’ Actual Historic Returns?” American Economic Review 97 (March 97): 386-401.
3. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. In US dollars. For illustrative purposes. The missed best day(s) examples assume that the hypothetical portfolio fully divested its holdings at the end of the day before the missed best day(s), held cash for the missed best day(s), and reinvested the entire portfolio in the S&P 500 at the end of the missed best day(s). Annualized returns for the missed best day(s) were calculated by substituting actual returns for the missed best day(s) with zero. S&P data © 2021 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. “One-Month US T- Bills” is the IA SBBI US 30 Day TBill TR USD, provided by Ibbotson Associates via Morningstar Direct. Data is calculated off rounded daily index values.
Disclaimer: Past performance is no guarantee of future results. Any indices referenced for comparison are unmanaged and cannot be invested into directly. Investments in securities involve the risk of loss. Nothing in this blog should be considered financial advice or recommendations. Your questions are unique to you and your own personal financial circumstances. You should consult with a financial professional before making a financial decision. See full blog disclaimer.