When you’re teaching [1] somebody a new subject, simplifications can creep in. Rules of thumb [2] at best. Outright untruths in the extreme.
For example:
- The simile “as blind as a bat” isn’t true – many bats see better than we do. (Maybe they’re also better than us at similes?)
- Christopher Columbus didn’t think the world was flat. The notion combines scientific and terrestrial exploration into a neat historical parable, but even the Ancient Greeks and Romans knew the Earth was probably a sphere. (Columbus owned books that told him so.)
- Teaching children the classical laws of motion wouldn’t be made any easier by telling them they’ll eventually learn the whole shebang is a gross simplification – that Newtonian physics is a shadow on the wall approximation of the statistical weirdness of quantum mechanics. (Yes, I know I’m oversimplifying here, too!)
- The “i before e except after c” rule often works – but not enough that foreign students can seize the weird exceptionalism of the feisty English language. (Spot the rule’s deficient idiocies there?)
So it is with investing. We say higher returns come with higher risks. That assets that go up and down a lot in price such as shares should to be held with a long-term view, and that braver investors can eventually capture higher returns this way.
But reality isn’t quite so simple. Those higher returns are only expected – not guaranteed – and not all risk is rewarded.
For starters, some risks don’t even come with the expectation of higher rewards:
…the relationship of more risk, more reward does not always hold.
In some circumstances you take greater risk, yet you can’t expect the market gods to reward your chutzpah with greater returns.
Academics call these lousy bets uncompensated risk.
Read our previous article [3] on uncompensated risk to learn if you’re gambling for nothing.
Not every stock market has read the textbooks
It’s also important to realize that even the ‘right kind of’ risk can go unrewarded.
You might expect higher returns, but higher returns are not guaranteed.
For example, we say investing in risky equities can be expected to deliver higher returns than super-safe government bonds. But there’s no guarantees, and no timescales.
Indeed there have been long periods where the return from bonds beat shares!
Over the ten years to the end of 2008 [4], for example, the annualized returns from US and UK shares were negative. In contrast, bonds soared.
So much for risk and reward over that decade.
And in case you’re thinking you can handle a ten-year duff stretch – and you will have to over a lifetime of investing – some have had it much worse.
How would you feel if your well-founded risk-taking wasn’t rewarded for half a century?
In 2011 Deutsche Bank reported that [5]:
…for three members of the G7 group of leading industrialised nations, Italy, Germany and Japan, returns from equities have been worse than those of government bonds since 1962.
Indeed, the Italian stock market has even managed to deliver a negative real return over the past half-century, -0.38 per cent on an annualised basis versus +2.64 per cent for bonds, “a remarkable statistic in a world where we are all used to seeing equity outperformance increase the longer you expand the time horizon”, wrote Jim Reid, strategist at Deutsche.
In Japan, government bonds have delivered a real return of 4.17 per cent a year, beating the 2.72 per cent of equities, while in Germany bonds have won by 4.28 per cent versus 3.46 per cent for equities.
Academics – and professional investors – struggle with findings like these. They go against the theory of efficient markets I discussed earlier.
For the market to get it wrong for 50-odd years might suggest:
- Those markets were unusual for some reason.
- We don’t have enough data. (A tossed coin coming up 10 times in a row doesn’t disprove probability theory. Try tossing it a million times.)
- The efficient market theory has limitations.
Personally I’d plump for a mix of all three in the case of Germany, Italy, and Japan.
But I’d also point out that all the leading efficient market academics hailed from the US, a country that has had the strongest, most consistent, and least ‘anomalous’ markets – with the best data, tracking a period including two World War victories, or three if you count the Cold War, and a transition from emerging market to sole global superpower status.
Could this very positive North American experience have biased the research or the conclusions? It seems feasible, but we’ll leave going down that rabbit hole for another day.
The important point here is expected returns are not guaranteed returns. Real-life investors in some countries never saw a sniff of them over a lifetime.
There are several important practical takeaways. For example, somebody on the point of retiring should not have all their money in equities, despite the higher expected returns.
Stock markets usually crash once or twice a decade, and that can chew up your higher returns in the short-term. That’s a big risk, especially for an imminent retiree or a newly-retired one. Statistically you might think it’s unlikely, but if it’s you, and you had no back-up plan, you’re somewhat stuffed.
This is called sequence of returns [6] risk. It’s not a reason to have no shares or own only gold, or any of the other dramatic things people write in the comments on blogs. It’s a reason to own fewer shares, and to diversify.
Risk in real life
I was set thinking about this recently by a family friend.
Having come into some money, she bought me that quintessential millennial brunch of avocado on toast and picked my brains about what to do with it. (The money, not the toast.)
My first step when this happens is usually to send over a bunch of Monevator links, and wait to see if they get read.
If the person doesn’t do their homework (and they usually don’t) then that helps inform where I steer them next.
But in this heartening case my friend read all the suggested articles, and she was keen to let me know so.
For example she explained to me that she now understood that she should never sell, that stock markets always come back, that you have to take risks to win… right?
Er, right, I said. Sort of.
It’s complicated!
Investing is like that. You have to learn a lot to realize there’s a lot you don’t or even can’t know for sure.
One excellent if rather gnomic definition1 [7] of risk is:
“Risk means that more things can happen than will happen.”
Whereas my friend had taken risk to basically mean “what goes down will come up.”
We can have expectations, given time, but there can be no certainty. If there was certainty, there’d be no extra risk. And if there was no extra risk then there’d be no expected higher returns – because they’d have been bid away by the market, at least in theory.
As blogger Michael Batnick says, you are owed nothing [8]:
This is how stocks work. The stock market doesn’t owe you anything.
It doesn’t care that you’re about to retire. It doesn’t care that you’re funding your child’s education.
It doesn’t care about your wants and needs or your hopes and dreams.
Batnick stressed in that article that he still believes shares are “the best game in town” for long-term investors.
But you must have realistic expectations about your expectations.
Shit happens
To conclude, I’ve long wanted to include this graph in a post. It’s from Howard Marks’ wonderful investing book The Most Important Thing [9]:
[10]The right way to think about risk.
Source: The Most Important Thing [9].
What this graph shows us is that expected returns do indeed increase with risk – but there’s a range of potential outcomes along the way. Some are dire. Plenty are bad.
It is a good graph to sear into your brain.
This graph is why most people are advised to use widely diversified stock funds, not try to find the next Amazon or Facebook.
It is the reason to hold some money in cash or bonds even when savings accounts pay you nothing and bond yields are negative.
It’s why we should stay humble and diversify [11] our portfolios across asset classes, even ten years into a bull market. (Or make that especially ten years in…)
As with many things, expect the best outcome when investing – but be prepared for the worst [12].
- I first heard it from Elroy Dimson of the London Business School. [↩ [17]]