What About the Risk?
Nothing in life is to be feared. It is only to be understood. ~ Marie Currie, Nobel Prize Winner
Welcome to RetireMentorship, Your Mentor To and Through Retirement. I am your host, Freeman Linde, Certified Financial Planner®.
Today we examine the “risk” of investing. I use that in quotes because so many people misunderstand what risk is and what it’s not.
That’s coming up on the RetireMentorship Podcast.
First, the RetireMentorship Two-Min Tune-In. The primary points of the podcast in two minutes.
We are told repeatedly by the public and professionals that investing involves risk. “Investing is risky!” But what does that mean?
When most people think of the riskiness of investing, they are thinking about the chance they may lose all their money. But that is only one form of risk, one that is easily removed.
There are three types of investment risk that we face. These may not be the academic definitions of risk. But they are the real-world versions that we will face. The three risks are:
Risk of Zero – The chance that the value of your investment goes to zero.
This risk is what most people think of when they think of risk. So when they are told that all equity investing involves risk, they think that all investments have the chance of going to zero. People who believe that all risk is the Risk of Zero are the ones that fall victim to the Fourth Horsemen: Panic. Everything is risky. Everything is going down. Therefore we better get out now before that happens. Or worse yet: They never invest in the first place because “Investing is risky!”
Risk of Change – The chance of drastic changes in the value of your investment.
This risk is otherwise known as “volatility.” Some investments are more volatile. They have a greater chance that their values will change drastically, for good or ill. The problem is that academics use the same word for volatility that they do for the chances of going to zero. They say that these investments are “more risky.” They mean they are more volatile, but when people hear is that there is a great chance they will go to zero. This is not always the case, and we’ll see why.
Risk of Diminishment – The chance that an investment’s returns may be lower than expected or required.
This risk generally applies to investments that are vaunted as good opportunities. The potential upside is that it could perform significantly better than other investments. The “risk” is that the actual returns may languish or be diminished. While it doesn’t go to zero, it doesn’t do what’s required. And after a few years of sub-par returns, you’ll never be able to come back from that.
The fact that all these risks have the same name led many to miss out on the fantastic phenomenon of equity investing. And it has led others to make catastrophic mistakes. Let’s look in-depth at each and why you need the correct belief about the “risks” of investing. That’s coming up on the RetireMentorship Podcast.
What About the Risk?
I am an Equity Evangelist! I believe whole-heartedly in the ownership of the great companies of the United States and the world. I believe that everyone, armed with a plan, a partner, and the proper beliefs, should own parts of these amazing companies. Everyone should be equity investors. I spread the good news of great joy that comes from lifetime equity ownership. I am an Equity Evangelist.
Here is a fun exercise. Find out what the S&P 500 Index was worth on your birthday compared to what it is today. For context, you can find prices back as far as January 1928, when the value was at $17.76.
As I write this, the S&P 500 Index is just about to break $4,000.
Put your birthdate firmly in your mind. Now guess what the S&P 500 was worth on that day. Go ahead. I’ll give you a minute. Firmly place a number in your mind of what you think the S&P 500 was on that date.
Now use the link in the show notes to find the index’s historical price on your birthday. You’re going to find that you were way off.
I’m thirty, so when I did this, I thought, “Hm, it was $18 back in the 20s, and it’s $4,000 today. If it was a straight line, and I’m looking at thirty years ago out of ninety, then it would be about $2,700 on my birthday. But compounding means that it has grown a lot in the last few decades. So I can’t just take a third of it. I’ll cut that in half. I’ll guess $1,500.”
What did you guess?
On my birthday, about thirty years ago, the S&P 500 was $397.
It’s now $4,000! That’s a 10x return!
And that doesn’t include dividends!!!
Use the second link in the show notes to pull up one of my favorite tools, the S&P 500 with Dividends calculator. On that site, you can pick the month and year of your birthday and show that total and annualized return with dividends reinvested.
If you do that for me, the $397 that I started with would have turned into over $8,000!
It’s amazing. And that’s just the S&P 500. A principly planned portfolio would have performed even better over that time, turning $397 into over $12,000.
Equity investing is amazing! Compounding. The eighth wonder of the world. Everyone should be equity investors, as long as they can follow the Seven Pillars of Victory.
And that’s not just for thirty-year-olds. Even those approaching or in retirement should own copious amounts of equities. Most retirees only have 30-50% of their portfolio in equities. But if you’re in retirement, or your parents are, and the retirement portfolio is not at least 70% equities, then you need to give me a call. That’s right. Retirees should have 70-80% of their retirement in equities. That’s not a recommendation to invest that heavily in equities. That’s an admonishment to speak with me if you’re not. You’re missing out on the greatest wealth-building and wealth-preserving tool ever invented: the publicly owned company.
I am an Equity Evangelist.
But no matter who I talk to about equity investing, the pushback is always the same.
“Equity investing is risky!”
“I can’t take the risk.”
“What about the risk?”
So what about the risk?
It is risky, but not in the way you probably think. So let’s look at the risks of investing.
First, when we talk about investing here, I am talking about long-term principled and disciplined investing. We are not talking about speculating or equity trading, which we’ll discuss in another episode. Those have their own sets of risks. We are talking about creating a financial plan, building an ownership portfolio of the best companies in the world, and sticking to that plan.
Let’s talk about the risks of equity investing. There are three:
- The Risk of Zero
- The Risk of Change
- The Risk of Diminishment
The Risk of Zero
The chance that the value of your investment goes to zero.
We’ve all seen it. The stories of people who invested and lost everything. Visions of World Com, Enron, and others. The worst-case scenario.
Imagine scraping and savings and investing for years and years, decades even, only to wake up one day and see a big fat $0 in your account balance. For many investors, this is their biggest fear and their worst nightmare. The risk of losing everything in the stock market. The risk of it all going to zero.
But how likely is this risk? What are the chances that your investments can go to zero?
It depends on what you invest in, of course. If you’re invested in individual companies, that is a genuine risk. If you have a bunch of your retirement in your company stock or have significant portions in other companies’ publicly traded stock, your investments could go to zero.
Companies do fail—even the big ones. Remember BlockBuster, Circuit City, Toys ‘R Us, and Kodak? And, of course, startups and other speculative investments fail all the time. If you’re invested in single companies or speculative startups, you are at the mercy of the Risk of Zero.
The solution to this risk in this situation is to diversify. It’s that easy. If you want to avoid this risk, don’t own single stocks, and don’t speculate. If you 2,500 companies spread across multiple mutual funds, the Risk of Zero is all but eliminated. Even if 10 of those companies fail and go to zero, that is 0.4% of your investments. You won’t even notice.
If you are properly diversified, you eliminate the Risk of Zero.
Can I even say that? Certainly I can’t guarantee that, right? There is still a chance that the economy will tank, and everything will go to zero.
Many people hold cash, CDs, bonds, and gold because of the fear of this risk. What if the economy goes down, and all the stocks plummet? Let’s go there for a minute.
Picture this: You are diversified across 2,500 of the biggest and best companies in the U.S. and the world. They are the best run, employing the top talent globally. They are the best-financed, owning cash, real estate, and intellectual property, amounting to stellar balance sheets. They make the best products and offer the best services that we all enjoy and use. And you are part owner in 2,500 of them.
And they all go to zero.
There is only one thing that could make this happen.
Total global collapse.
If that happens and the equity of all those companies turns to nothing, how are your corporate bonds going to fair? That guaranteed interest rate is guaranteed to be nothing.
What about CDs? When all the banks have failed, are your “safe” CDs going to be worth anything? Certificates of Depression.
How about cash? Cash is safe. In total global collapse, where are you going to spend it?
Surely gold will end up being the currency. We will revert to the “true” gold standard. Are you going to be wanting to lug around heavy gold when the world is falling apart?
In the event of total global collapse, there are only two things you should be invested in: Bullets and Baked Beans. Ammunition for the global guerrilla warfare and canned food when the economy is no longer producing it fresh.
If you are anxious about global economic collapse, join the doomsday preppers movement and get yourself a bunker and some rations. But that’s a separate issue from retirement investing. It has never happened, it may never happen, and it is surely not something we can create investment policy around.
So yes, I’ll say it. If you are properly diversified, there is no Risk of Zero. If I end up being wrong and all the best companies in the world go to zero, then you can sue me. Good luck with that.
The solution to the Risk of Zero is to get a proper investment plan with a properly diversified portfolio and stick to it. The Risk of Zero is not a real risk to a good equity investment plan.
Risk of Change
The chance of drastic changes in the value of your investment.
The “risk” people are often talking about regarding equity investing is the Risk of Change: the chance that your equity investments’ value will drastically change. This happens all the time. The values of equities constantly fluctuate. Of course, when people refer to it as “risky,” they aren’t talking about when the change is positive. They only mean it when the change is negative.
It’s called “volatility.” The values of equities and equity funds are volatile, some more than others. The more volatile an equity investment is, the more “risky” it is said to be. Which, when applied to a fund of high-quality equities, is a misnomer. Let’s not confuse “risk” with volatility.
Sure, some equity funds are risky both in the sense that they are volatile in the sense that they could go to zero or face the third risk. But in that case, we are talking about small funds of companies investing in startups or small countries around the world. But those funds are rare, and most people aren’t in them.
Let me say the following statement very clearly.
Volatility is not your enemy.
There is nothing wrong with volatility. It’s “scary” only because we’ve been taught to think it so. It does not matter what happens to the value of your investment while you hold it. Only three things matter:
- The value on the day you bought it.
- The value on the day you sell it.
- The difference between those two values relative to the time between those two days.
Everything in between is noise.
The point of investing is to increase your net worth. It’s to make money. You do that by purchasing things that pay you (such as dividends) and that increase in value. The point of investing is not to reduce volatility.
But we in the investment industry and we as investors have confused those goals. It’s a chicken in the egg situation as to which came first. It has been a spiral of investors being more afraid of volatility and professionals happy to oblige with new products and theories to decrease volatility, thereby communicating that investors should be afraid of it.
Whole methods have been produced with one goal in mind: reduce volatility. Modern Portfolio Theory, the Efficient Frontier, investment betas and standard deviation—all with the goal of achieving better returns with lower volatility. But why?
Say you have $1 million invested, with ten years before you need any of it.
Investment Strategy A uses a complex equities and bonds strategy, with a core and satellite approach, interlaced with inverse ETFs, momentum-based trading, commodities, and real estate futures. The goal is to maximize returns while lowering volatility (mistitled “risk”). The strategy turns your $1 million into $1.5 million after fees over seven years, with three years to go before you need it. And they achieve this will relatively low total portfolio volatility due to all the contrasting strategies.
Investment Strategy B uses a simple equity investing strategy combining disciple, patience, and rebalancing to turn the $1 million into $2 million in the same seven years, albeit with significantly more volatility. You take on some volatility and an additional $500,000. And you still have three years to ease some of it out into what we call a “blue bucket” before you need it—more on that in a future episode.
Investing with the goal of making money while reducing volatility is like exercising with the goal of strengthening your heart and muscles while reducing sweat.
The point of exercising is to strengthen your heart and muscles so that you have more energy, feel better, and live longer. An unfortunate side effect of that is that you sweat. There are ways to work out where you reduce the amount that you sweat. But that goal is somewhat incompatible with the ultimate goal. In the end, there is no way to reduce sweat without also reducing the effectiveness of your workout. You can’t be afraid of a little sweat. Just create routines around it, such as showering before going to work. Problem solved.
If you want to be healthy, you must embrace the sweat.
If you want to be wealthy, you must embrace the volatility.
Simply create a plan around it. Don’t try and avoid it. Deal with it.
Volatility is not to be feared. It is only to be understood. We’ll do a future episode on creating an investment plan that deals with it instead of trying to avoid it.
Risk of Diminishment
The chance that an investment’s returns may be lower than expected or required.
The last risk is somewhere in the middle. It’s not quite the risk that your investments will go to zero, which you can eliminate. And it’s not quite volatility, the ups and downs of the market which can be planned around. The Risk of Diminishment is this: What if the investment goes down and takes forever to come back? The quick downside of volatility with a slow upside?
Or even without a downside, what if what you initially invest in simply doesn’t do as expected?
First, let’s look at this from a total equity market side, then an individual fund side.
Some have asked if we can expect historical equity returns in the future. Sure, the S&P 500 has averaged 10% total return since 1957, and even over the last 30 years. But will it continue to do that? What about all these “experts” that point to equity returns being lower going forward, perhaps as low as 7 or even 6%? Is it worth taking on the “risk” of equities if the returns won’t be as high? What if future returns are lower than expected or required?
Let’s first acknowledge that we can eliminate the Risk of Zero, and volatility itself is not a risk. It’s something we can plan for and around. So the question is, “Is it worth it to take on the volatility of equities if the returns are not as high?” A crucial distinction. Before exploring correct answers, we must first ensure we are asking the right questions.
And that is a fair question. We just stated that the point of investing is to make money, not to avoid volatility. But what if the money you are making is less? Then what?
What if equity returns are lower?
The answer: They will still have the highest real relative returns.
This is a crucial concept that will get its own episode. But in short, it does not matter what the nominal returns of any investment are. What matters is
- The real returns: the amount over inflation, and
- The relative returns: the returns compared to any other option.
Let’s say historically that
- Equity Returns were 10%
- Fixed Income Returns were 5%
- Inflation was 2.5%
Equity annualized returns were twice that of fixed income, amounting to a dollar difference of 4 times as much over 30 years. So over thirty years, equities have had a relative return to fixed income alternatives of quadruple!
Equity annualized returns were quadruple that of inflation, leading to a real dollar return of 10 times inflation. A two-liter that cost $1 went to $2 for the same bottle. Meanwhile, your invested equity when from $1 to $20. You can afford the $2 two-liter.
Now let’s look forward. Let’s say that over the next thirty years
- Equity Returns are only 7%
- Fixed Income returns are 3.5%
- Inflation is 1.0%
Equity annualized returns are still twice that of fixed income (relative returns) and seven times inflation. In thirty years, your $1 item will end up costing $1.35, while your $1 equity investment will be $8. Not as good as the first scenario, but still fine! And certainly better than the $2.85 your fixed income will reach.
Over time, equities have always had the best real relative returns over fixed income and inflation. So even if the broad equity market returns are expected to be lower, everything else will be lower as well.
As for individual funds, that may be another matter. Of course, owning individual stocks always runs this risk. There is an excellent chance the stock of a single company performs worse than expected. But, as with the Risk of Zero, we can diversify away that risk.
But what about whole funds. What if we invest in a whole fund, or sector, or style, and it performs much worse than expected in the future. What about the risk of that happening? What are the chances that happens?
This risk can be partly addressed by good investment portfolio construction. Choosing funds and styles that have performed consistently well over lifetimes give us the best chances of avoiding this risk in the future. Where the chances of lower performance are greatest is with funds constructed around new ideas and untested theories.
This happens a lot with new investment formulas and strategies. They appear promising at first and may even have a few good years. But then they begin to sag and never live up to their hype. If you’ve fallen for one of these new strategies, there may be no hope for recovering those lost gains. Take your medicine and move into strategies that are time-tested and approved. Stop trying to make a killing, and you’ll stop being killed. Patience and discipline are the requirements, not chasing returns and poor diversification.
Lastly, this could happen to an otherwise historically good style. Perhaps you have a lot invested in Large Cap Value companies because historically they’ve performed well. Perhaps, though, they never do so again, and they continually lose out to growth and small companies for the rest of your investing life. While a good investment style may go sour, it’s unlikely and unknowable to which it will happen. And you can’t make an investment policy out of unknowables. The risk of this happening is smaller than the risk of being left behind entirely due to fear of equity investing.
The bottom line: you must invest in equities. You must have a solid equity investing plan, funded by an equity portfolio that you operate with patience and discipline. It remains the right way to realize real relative returns.
With a properly constructed and diversified investment plan and portfolio, you can eliminate the Risk of Zero and most of the Risk of Diminishment. With the right plan and belief, you can embrace and leverage volatility instead of being afraid of it.
What about the risk? What risk? Eliminate the real risks, and embrace volatility. That is the path the wealth.
Find an Equity Evangelist to help you build that plan and portfolio. Then flourish.
Thanks for listening. We’ve reached the end of Season 1. We’ll be back in May with another season to help you build your belief in financial planning and wealth building. In the meantime, stay subscribed for mini bonus episodes to hold you over.
I look forward to catching up with you soon!
This article is educational only and is not intended to be investment, legal, or tax advice or recommendations, whether direct or incidental. Again, this is not investment advice. Consult your financial, tax, and legal professionals for specific advice related to your specific situation. Never take investment advice from someone who doesn’t know you and your specific situation. All opinions expressed in this article are the opinions of the people expressing them. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. RetireMentorship is not affiliated with any Registered Investment Advisor, Broker-Dealer, or other Financial Services Company.