You’d think we’d know better by now. Unlike our forefathers who traded houses for tulips and bought US railroad stock on hock, we’ve got behavioural finance to remind us our caveman brains go all Harlem Shake when trying to weigh up risk and return.
But no, even now there lurks inside each of us a Jekyll and Hyde investor, itching to run with the herd, to jump off a cliff, and to generally get emotional about what should be the rational business of investing.
And so risk in investment swings from meaning the fear of losing money to the fear of missing out – just like it did 100 years ago, and 300 years before that.
In a deep bear market, all the talk is of capital preservation. Having lost their shirts, investors fear losing their pants.
In contrast, when markets hit new highs you’ll hear far more about the risks of missed opportunities. The foolish chase hot shares and funds, and may even abandon their asset allocation altogether.
You say risky, I say risqué
The start of 2013 was a case in point. In just four years we’d gone from a stock market crash – and talk of the death of equities, of buy-and-hold investing, and of capitalism itself – to a roaring bull market.
It seemed that almost overnight many more people agreed that cash was trash, bonds were in a bubble, and equities were the only game in town. Yet precious few of these voices were heard when shares really were cheap.
Worse, such opinions seldom come with even a nod to individual circumstances.
- If you’re 25 and you will invest regularly for the next 30 years – and if you’re made of stern stuff – then a 100% equity strategy may well be the way to get started.
- If you’re 55 and you’ve done most of your saving, being 100% in equities is probably not for you, not matter how crummy the alternatives.
Your aim in investing should probably not be to try for the maximum possible return – or even the most likely maximum return.
Your aim is to meet your investment goals. The big risk is you don’t.
Beta not pay too much attention
Even those two different uses of the word “risk” – of losing it and of missing out – barely begins to cover risk’s many guises when it comes to investing.
For example, to academics the upside and downside risk of a share is treated as the same thing. When they say risk, they are talking about how far shares or other assets have previously moved up or down in price terms, compared to the market – something we might instead call volatility.
This academic idea of risk (called beta) is extremely useful when you’re neck-deep in theoretical portfolio construction.
But even if you believe market efficiency underpins all our investing choices, in my opinion their notion of risk is not of much practical use, whether you’re a passive investor working out a retirement plan or a value investor looking for bargains.
Passive investors should be more interested in asset allocation and the likely range of potential returns over the long-term – and in the prospects of falling short of their goals.
And value-minded stock pickers?
We should laugh at the proposal that Sainsbury shares at 240p in 2009 were a higher risk investment than at nearly 600p in 2007, whatever the academics say.
Time, investment, and risk
There are myriad other kinds of risk in investment – from currency risk to political risk to interest rate risk.
But the main one we’re interested in is the risk of permanently losing money.
Here academic notions of risk as volatility can make peace with a more common sense idea of risk as the chances of living off baked beans in your old age because you blew your pension spreadbetting.
The academic sort of risk – volatility – increases over time. But the deviation of your annualised returns versus those you expect based on historical precedent tends to decline over time. The UK stock market has fallen 20% or more in a year several times, for instance, but it’s never delivered a minus 20% annualised return over a decade, or anything like it.
This graph from Barclays Capital makes the point clearly:
Note how the range of returns decreases the longer you hold
The longer you hold a basket of shares, say, the more confident you can be of achieving the expected returns.1 Investing in shares is less risky over the long-term, than it is in the short-term.
This is why we’re advised to reduce (not eliminate!) the amount we have invested in the stock market – the riskiest asset over shorter periods – as we age, and to increase the proportion of less volatile assets like cash and bonds. We simply have less time ahead for the superior returns we expect to earn from shares (on average) to compound and outpace their year-to-year volatility, and so we can’t be confident of getting the return we’re banking on.
Note this doesn’t mean share prices, say, won’t keep going up after you sell a few. The stock market was doing its thing long before you arrived and it will trundle on long after you do. It’s a tool, not a competition.
It also doesn’t mean that my 70-year old mother and I can’t agree that, for example, the stock market looks good value whereas bonds seem expensive.
But it does mean the damage done if we’re both wrong is potentially far greater for her than it is for me, if she ignores the rules of thumb about asset allocation and holds the same proportion in equities as I do.
I have time on my side. She does not.
Don’t risk losing sight of your goals
I’ve had spirited discussions on Monevator with readers who were all-in cash, others all-in equities, one or two who were all-in emerging markets, and even one who was 100% in gold.
All the individuals concerned are articulate, personable-sounding folk that I enjoyed arguing the toss with. But obviously they can’t all be right, given that their positions contradict each other.
Luckily, being right or wrong is a risk you don’t have to take.
By all means favour some asset, sector, or geography if pure passive investing isn’t your game. But be very wary of betting the farm, especially if you’re closer to the end of your earning years than the beginning.
At some time or another, all asset classes and stock markets around the world have delivered unexpectedly terrible returns for years on end. You only live once, and I doubt you’re here to discover how it feels to be all-in on the next Japan.
By diversifying across assets and countries – and by not going entirely in or out of cash, bonds, equities, gold, property or anything else, even when you suspect you’re slightly reducing your returns by doing so – you can make sure that the all-in-a-sinkhole feeling is somebody else’s fate.
Howard Marks puts it very well in The Most Important Thing, his wonderful book on investing:
We may have an idea which one outcome is most likely to occur, but we also know there are many other possibilities, and those other outcomes may have a collective likelihood much higher than the one we consider most likely.
[Given this] we have to practice defensive investing, since many of the outcomes are likely to go against us.
It’s more important to ensure survival under negative outcomes than it is to guarantee maximum returns under favourable ones.
True, I guarantee that by diversifying you won’t win – not in the very narrowest sense of the word.
Some particular slice of some asset class or another will be the top performer over the next decade. If you’re diversified, you might well own a bit of it. But someone somewhere will own nothing else.
Putting up with the boasts of the reckless few who bet everything on black and won (or who claim they did) while remembering the silent losers who went all-in on the wrong horse is all part of the challenge.
But my idea of winning investment starts with avoiding losing, and with always remembering why I began investing in the first place.
- You can never be entirely confident. Stock markets sometimes get nationalized. Governments default. Cash falls to hyper-inflation. [↩]
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“In contrast, when markets hit new highs you’ll hear far more about the risks of missed opportunities. The foolish chase hot shares and funds, and may even abandon their asset allocation altogether.”
This is something I think about all the time; people think short term and are way too reactionary with their investments.
One of my favorite investing quotes is from Warren Buffett. He was asked what the ideal holding period for a stock is. He famously answered, “Forever.” Everyone could take a lesson from this. He buys solid investments with big moats and ignores the whims and fluctuations of the market. You should too.
“You think we’d know better by now” – wise words.
How could anyone think that putting everything on APPL would be a good idea, however young they are http://www.thereformedbroker.com/2013/03/06/are-you-fing-kidding-me/
Good asset allocation reduces beta, so theya re not alternative or contradictory approaches. However, beta measures the risk relevant to DCF valuation, which is not always what you want.
The academic theories to cover the types of risk you are talkng about as well: things like value at risk.
The problem is that they work best over the short term (because of the lack of data with which to measure long term risk) – the bank’s brilliant credit risk models neglected this problem.
That said, its probably worth knowing what the short term risk is. IF nothing else its a starting point for getting a feel for how risky a portfolio is.
@Graeme — Good additional points, and I did over-simplify a little to avoid getting bogged down. That said, at least some of the great investors I respect most have a somewhat disdainful attitude of value at risk; they see another way to compute risk through history and numbers, not through trying to assess the quality of the underlying business. (Granted, I’m sure that’ll work better than most stock pickers DIY attempts to do the latter).
@PC — That Apple story is unbelievable, isn’t it? It boggles the mind.
@Mr. 1500 — One of the few ways I disagree with Buffett’s wisdom is his 20-card punch hole concept for stock pickers. I think one is missing a great opportunity from a liquid market if one has to find the 20 best investments for all time, let alone 20 that will do well / beat the market (already supposedly an impossible feat).
*However* I do agree with him that it’s a good way to *think about* your potential investments. With a fair bit of my actively invested money nowadays I’m trying to find and invest in these ‘forever’ companies, but then to reduce a little when they seem to get carried away, and to add when they fall. (Rather than staying all in for 40 years or selling out on what seems to me mild over-valuation).
I don’t really understand how we can be in a bull market now
Everyone seems to think that central banks printing money and throwing it at commercial banks can defeat any real world problem
There just seem to be a lot of real world problems that are being ignored, not solved
@Neverland — I don’t think anybody really understands QE, even Ben Bernanke, but I’m more sanguine about it than most.
One might think of it in simplified terms a bit like this. Imagine I had a beloved cousin whose house had fallen 20% in nominal terms, and who was struggling to meet the mortgage payments. She can’t sell and get out of the debt because prices have fallen, and she has to meet the payments.
I offer to help tide her over with a £10,000 loan to top up her mortgage payments, because I am very confident that both her house will one day be worth 100% again — if only due to inflation — and because I think in the long-term she’ll be able to meet her payments and repay me the £10,000.
In the meantime I also go through her finances with her, cut down on dodgy credit card spending, suggest she spends a few nights in with the TV instead of out on the town, and so forth.
Her life gets back on track. She works, spends, meets her payments. All that activity is ‘real’, even though if I’d not given her the loan she’d perhaps be bankrupt. The downside is she is carrying an extra £10,000 debt that she’ll have to pay off.
I see QE as similar, particularly in the US. Asset prices collapsed, in some cases because they were far too high, in other cases because of fear and illiquidty. To offset this, Central Banks printed money to stave off depression. At the same time the weakest banks have folded, all the banks are much more closely regulated, companies have fired lots of workers and become more efficient, etc. (So while not all real-world problems have been solved, at least some have been partly addressed). Economic activity is returning.
To my mind all this activity is “real”. There is a cost/downside, which is that future growth will be lower because at some point this stimulus must be withdrawn from the economy / the pseudo-debt to the future repaid. So it’s not scott-free, which some critics seem to think QE’s advocates are saying. The central bankers bet is that over a few cycles this approach will overall cost less/cause less harm than if they’d allowed a Great Depression. I think they may be right.
I agree there’s a side-effect that it has given politicians more time to pontificate about restructuring public finances. But I don’t agree nothing is being done. Even in the US progress is being made, albeit in a stop-start laughable manner.
What happens when interest rates rise in the US , it’s only sustainable whilst they keep them artificially depressed which surely cannot last indefinitely , then the game is up.
Inflation adjusted the market is still far from where it was in 2007 so i’m still happier to be all in with equites given i have 25-30 years investment horizon & i only need to take an income from them so i no longer care what the share price does on a short term basis.
I’ve looked at the asset allocation models & they make sense , they really do .. but i have to do what is right for me & history tells me over many decades good quality smaller company’s in a variety of sectors & countries will give me a better result.
So i stick my head on the line rightly or wrongly & if i end up eating beans , have you got any toast !
Think you might be getting a bit muddled here about risk/volatility. Volatility does NOT go down with time – it goes up. It just so happens that volatility rises with the square root of time, but growth is exponential (compounding), so the effects of growth outpaces volatility in the long run. Or more accurately, has in the past.
@NaeClue — Hmm, I don’t *think* I’m confused but I agree I might not be being very clear/correct.
What I mean is the deviation of returns on an annualised basis.
So you might see +/- 40% say from the market in one year, but over ten years likely say +/- 10% on an annualised basis. (Note all — not real numbers!)
I tried to capture that with my phrase ‘volatility of returns’ but I think I should revisit the piece to be more precise. Thanks for flagging it up! 🙂
Reads much better now. To illustrate the point I was making about volatility going up with time, look at your Barclays Capital chart. This shows returns over 1 year between -40% and +55%. The 20 years annualised returns looks like +0.5% to +10%, which over the 20 years works out at between +10% to +573%. So the volatility over 20 years is much bigger than the volatility over 1 year. It is the taking of the 20th root that reduces the spread.
Sorry if my comments appear brusque. I really like your site – we need more people like you highlighting the advantages of passive investing. There is a huge wall of money attempting to push retail investors into expensive, poorly performing actively managed funds.
@NaeClue — Cheers, it was good feedback. Glad you’re enjoying the site!