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:
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:
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.
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