The Real Risk of Investing in the Stock Market

risky business

I’ve written a lot on here about the benefits of investing in the stock market. I’ve also written articles specifically addressing the risks involved in other types of investments (see here, here and here) and compared them unfavorably to investing in the stock market. Looking at just these articles, it might be easy to conclude that I believe the stock market to be relatively risk-free when compared to other investments.

Actually, I believe that investing in the stock market carries with it a very large risk, one that is rarely talked about in the financial media. Today I want to address that risk head-on so we can all understand exactly what we’re getting into when choosing to invest in the stock market.

Success and failure are not the only outcomes we should measure

Last week Michael Kitces wrote a great article that brought up a number of important points, one of which is the fact that investment risk is often characterized too simply as success or failure. The problem with viewing investment outcomes as simple success/failure propositions is that both success and failure can come come in varying degrees. One route might give you a small probability of failure, but that failure would be very large (e.g. missing your retirement goal by $1,000,000 dollars). Another route might have a higher probability of failure, but any failures would be much smaller. It’s important that we pay attention to the degrees involved here so that we can make decisions that truly align with our risk tolerance.

Stock market risk increases over time

This point reminded me of an outstanding paper by John Norstad that goes into great depth on this exact topic. The traditional measure of investment risk is called standard deviation, which essentially measures how much the return on an investment should vary from period to period. As you increase the length of time you stay invested, standard deviation decreases. By this measure, it appears that stock market risk decreases over time, and that is in fact the popular opinion expressed in almost every article on the topic. It is often the main point used when encourage young people to put most if not all of their investment money into the stock market.

Norstad refutes this notion that investment risk decreases over time. His point is really quite simple, though he goes into a lot of depth proving it. While he acknowledges that the standard deviation of returns does decrease with time, he shows that that fact is largely irrelevant. What people need to be concerned with is not their return, but the amount of money they actually end up with. When viewed from this angle, it becomes quite clear that the range of possible outcomes, including the bad outcomes, increases dramatically as the length of time you invest increases. Check out the chart below taken directly from his paper:

norstad risk and return

 

What this is showing is that the longer you stay invested, the bigger your possible spread of outcomes. Investing for 40 years gives you a better chance of the great outcomes (living it up in the French Riviera, woo hoo!), but it also gives you a much better chance of the really bad outcomes. At it’s core, it’s simply saying that the longer you invest, the less certain you can be about the outcome, both for better and for worse. It’s the potential “worse” that people need to understand from a risk standpoint.

Let’s look at an example

This paper from Vanguard has a good discussion on how investors should think about their investment time horizon, but I want to focus on one piece of the paper that serves as a good example of what I’m talking about.

On the fifth page, it provides some risk-return data using actual stock market returns from 1926-2006. On one hand, it illustrates perfectly the conventional wisdom that time decreases risk. Over 1-year periods, the stock market’s average return was 10.45%, but it’s standard deviation was 20.20%. This huge amount of variation is exactly why people warn against investing in stocks for the short term.

When looking at 30-year periods, however, the picture changes dramatically. All of a sudden the average return is 11.30% and the standard deviation is only 1.38%. When viewed only through the lens of those numbers, it does indeed look like all you need is time to eliminate almost all of the risk involved with investing in the stock market.

But let’s take a second to really look at what those numbers mean. Let’s say that you’ve decided that in retirement you will need $40,000 of income each year. Let’s also assume that you have 30 years to save for retirement and look at a couple of the possibilities, using the numbers from the Vanguard paper:

investment risk

The first row shows you the results if you save $4,262 per year and get the average 11.3% return. You’ll end up with almost exactly $1,000,000, which according to the standard 4% safe withdrawal rate will provide $40,000 per year in income. You have a 50% chance of achieving this result or better.

The second row looks at the results if you fall just one standard deviation from the average. Your return is still 9.92%, which sounds great, but if you’re saving that same $4,262 per year you will only end up with enough savings to provide about $30,000 of income in retirement. That’s a 25% shortfall! And this result (or something worse) isn’t all that unlikely, occurring about 1 every 6 times.

This example clearly shows that it’s not just the risk of loss that you need to be worried about. It’s the very real risk of shortfall that matters as well. That risk of shortfall is actually increased with time and increased as you invest in riskier assets (i.e. stocks).

What does this mean for deciding on an investment strategy?

So does all of this mean that you should avoid the stock market? Of course not. All investments come with risk and all this is showing is that stocks are no different. One of the stock market’s biggest strengths is that over the long-term the expected returns are largely worth the risk. But it’s important to remember that nothing is guaranteed and to take steps that reduce some of the risk involved, according to your personal risk tolerance.

One way I’ve chosen to decrease some of this risk myself is by putting 30% of my investments into US government-issued Treasury bonds. These are some of the safest investments out there, and the primary purpose of this part of my portfolio is not to provide returns, but to provide protection during periods where stocks are not performing well. While most of my money is in the stock market, and will hopefully deliver the high long-term returns that only the stock market can deliver, at least some of my money will be shielded from significant market downturns.

It’s also important to consider what kind of risk you want to take on. Investing more in stocks may give you a higher probability of reaching your retirement goal sooner or by saving less, but it also exposes you to greater risk of falling far short of your goal. A more conservative approach with more money in bonds might require you to save more or save for longer, but it will give you more certainty about reaching your goal.

Another consideration is using a conservative return estimate when determining how much you need to save for retirement, or whatever other goal you’re shooting for. Like adding more bonds to your portfolio, this would result in you either having to save more or save for longer, but it leaves you with more certainty about the outcome.

Conclusions

There are no right or wrong answers here about how to handle the risk involved with investing. The best you can do is understand the risks involved and use that information to make decisions that fit your goals.

Photo courtesy of Paxson Woelber

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24 comments… add one

  • Alexa Mason August 23, 2013

    I’ve got to admit that when it comes to the stock market most of the articles are way over my head. I do appreciate the detail that you go into to explain things though. When I start investing I am just headed toward the simplest route possible. Hopefully you’ll be able to give me a few suggestions when that day comes.

  • DC @ Young Adult Money August 23, 2013

    One thing I’m really happy about as a 20-something is that I have such a long investment horizon. At the same time I am definitely aware of the fact that there is no guarantee of x return in the stock market, even over the course of a few decades. Great post!

    • Matt @ momanddadmoney August 23, 2013

      Hopefully this research brings home the point that a long time horizon isn’t all it’s cracked up to be. The longer the time horizon, the more variability in final value, which is really all that we should be concerned with.

  • Your Daily Finance August 23, 2013

    No risk no reward but be smart about how you risk and when you risk. I like the stock market and when you are up things are golden when the pain comes people are quick to jump ship. Take profits, buy on the dip, and stay in the market for the long haul. Don’t bounce around from stock to stock chasing dreams. You will more than likely always miss the boat. Great post Matt!

    • Matt @ momanddadmoney August 23, 2013

      Exactly. There’s always risk but you need to be smart about where you take it. The stock market is one of, if not the, smartest places to take risk, but the risk is still there. And as you say, staying in the market for the long haul is the way to do it. You’re only locking in losses when you panic.

  • Pauline @ MakeMoneyYourWay August 23, 2013

    I don’t mind risk at all but would probably get more cautious with age and having a family. Not a fan of the stock market though but I am thinking more and more about getting just a few classic stocks and holding them forever.

    • Matt @ momanddadmoney August 23, 2013

      Why do you prefer holding just a few stocks as opposed to the market? Do you have faith that those few stocks will stand the test of time above and beyond business in general?

      • Pauline @ MakeMoneyYourWay August 23, 2013

        no, I have no faith in general in the stock market, well not much anyway, maybe because I am not taking the time to understand it but I believe you can’t be virtual forever, even currencies not based on a real gold exchange standard are quite the risk and that is why I like to have tangible assets like a house or even some cattle. How will P&G or Coca Cola be doing by the time I retire no idea, and having an index would be about the same, but I would not put a large % of wealth in the market.

        • Matt @ momanddadmoney August 23, 2013

          Fair enough. Stick with what you know. Although I’m not sure what would happen to the real estate market, or any other market for that matter, if businesses (and therefore the stock market) totally collapsed. It seems to me like that would really be the end of the modern economy as we know it, in which case no investment would really be safe.

  • Andrew August 23, 2013

    I think I’m about 15% in bonds…I probably should be more diligent in checking that out. I feel like I can take on a little more risk because I have a pension. I’m also confident that the stock market will have a higher return in the long term.

    • Matt @ momanddadmoney August 23, 2013

      Having a pension definitely allows you to take more risk elsewhere, assuming the pension is secure. But the point here is that while the stock market is certainly likely to have a higher return, the times where it doesn’t can have a big negative impact on your savings (even if the returns themselves are still positive).

  • Shannon Ryan August 23, 2013

    Incredibly thorough post, as always. Risk tolerance is always an interesting conversation. It too often fluctuates based on what the market is doing, rather than their true tolerance to risk and with consideration to their goals and timeframe. Investing is emotional and investors as a whole are highly influenced by what others do, hence the stampedes in and out of market without slowing down to figure out what’s right for their personal situation. So many pick their risk tolerance in the moment, rather than considering the ups and downs of a normal market.

    • Matt @ momanddadmoney August 23, 2013

      Couldn’t agree more. Very few people truly know how to evaluate their risk tolerance or really even think about it in terms of searching for a stable portfolio. The emotionally-driven back and forth you describe is so devastating.

  • Done by Forty August 23, 2013

    This is a fantastic breakdown of risk and what it really means. Thank you, thank you for this post. I’d read the Nerd’s Eye View post earlier (okay, I read most of it) but he is way too smart for me to follow. I really appreciate the breakdown here, as it’s more accessible for me.

    Part of the reason we’ve paid off the home is to dramatically reduce the amount we’ll need in FI. While the math says we’d be better off investing the money instead, our gut told us this would pose much more risk to our stated goal of achieving FI in the next 8 years. As you noted, it’s not just risk of returns/losses, but actual risk of shortfalls and not achieving the goal. Am I interpreting the post correctly?

    • Matt @ momanddadmoney August 23, 2013

      Kitces is definitely incredibly smart and thorough, and I have to admit that I can’t always completely follow all of his posts either. They’re really written for professionals, which I am not, but I find them consistently unique and through-provoking. Thank you for the kind words.

      I think the tradeoff you describe in paying off your house is a good example of choosing what kind of risk you want to take on. Investing more instead of paying down the mortgage brings you the expectation for higher returns, but not the guarantee of lower expenses. I think that either route can be a good one, but the important thing is that you choose one you’re comfortable with and that aligns with your goals.

      And yes, you’re absolutely right that risk is not really about returns and losses. It’s about the chances of reaching your goal, and additionally how big a shortfall you might face. A high chance of a small shortfall might not be a big deal, which a small chance of a huge shortfall might be too much risk to take on.

  • MoneySmartGuides August 24, 2013

    Excellent breakdown. It’s easy to be successful investing in the stock market when you first understand how much risk you are willing to take and then create a long-term plan around that risk. If you picked the correct risk tolerance, the daily swings in the market shouldn’t bother you. If they do, then you picked an allocation that carries too much risk for you.

    One last note, you have to focus on the downside when assessing your risk. Everyone wants to earn the highest return possible. But that highest returning assets are also the ones that will drop by the same amount. If you are think you want a 20% gain but couldn’t stomach a 20% loss, then you can’t go for that large of gain.

    • Matt @ momanddadmoney August 25, 2013

      I think it’s pretty difficult to know your risk tolerance as you start out, and even as you go along. You definitely need to experience a real down market before you can get a good sense of where you stand. The important thing to keep in mind is that you’re searching for a balance between returns and, as you say, downside risk, but you have to accept that there’s a compromise. You can’t find a way to get returns while avoiding the risk.

  • David Sandy August 25, 2013

    Well I believe the conventional wisdom is to start with riskier stuff like stocks and ratchet your exposure down as you approach retirement age. What do you think of that approach. Depending on the maturity of those bonds you could be taking very substantial interest rate/inflation risk.

    • Matt @ momanddadmoney August 25, 2013

      The conventional wisdom partially plays off the assumption that risk decreases with time, and in that case may have some holes. But there’s also an argument to be made that your human capital is greatest when you’re younger, and that that functions like a kind of bond and you can therefore take on more stock market risk as your younger. As you age and your human capital decreases, you would shift your investments more conservatively as you mention. Inflation is another argument for keeping your money in higher-returning assets when you have many years of investing ahead of you.

      You’re absolutely right that bonds and other conservative investments come with their own risks. There is no perfect strategy. My hope was simply to help people understand that stock market risk does not disappear with time.

  • Greg August 25, 2013

    I tend to think of the stock market as a necessary evil. There is definitely plenty of risk, but when compared with other options for your money, it is likely to yield the best rewards. Stay diversified to mitigate the risk and you should be in pretty good shape to see a better return than you would with other investments.

    • Matt @ momanddadmoney August 27, 2013

      Absolutely. I definitely think it’s a great place to be invested, as evidenced by the fact that we have most of our investment money in the stock market. But doing what you can to understand and mitigate the risk while keeping on track for your goals is definitely an important step.

  • Kam September 14, 2013

    Hi ..I’m just curious as in your article you write “The first row shows you the results if you save $4,262 per year and get the average 11.3% return. You’ll end up with almost exactly $1,000,000″..so when I calculate $4262 x say 30 years of working it equals $127,860 ..how is your example a million dollars ?..

    • Matt @ momanddadmoney September 14, 2013

      Hi Kam. Thanks for the question. You have to factor in the 11.3% return you’re earning each and every one of those 30 years in addition to the contributions you’re making. You can use the calculator at this site to run the numbers for yourself: http://www.moneychimp.com/calculator/compound_interest_calculator.htm. To run this example, the “initial balance” (what you’re starting with) is $0, the “annual addition” is the $4262, the “years to grow” is 30, and the “interest rate” is 11.3%. The you hit “calculate” and it comes to just over $1 million. Let me know if that makes sense or if you still have any more questions.

      As an aside, 11.3% is not a realistic expectation for returns, it’s just what was used in the single paper I cite in the article. For long-term returns you’re better off assuming 6-8% and to also consider the impact of inflation.

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