How Risky Are Stocks?
My kids are incredibly resilient. They seem to experience an incredible number of setbacks every single day. One moment it’s a skinned-knee, the next it’s heartbreak from not being able to have ice cream for dinner. Then, one pushes the other, someone falls down, and cries, shrieks, yells, obviously upset. At three and five, there is plenty of crying. Always plenty of crying. Though it never lasts long.
No matter the issue, big or small, my boys keep moving forward and making progress. A quick hug, high five, whatever, and they’re back on their feet not missing a beat. All it takes is a little time. They don’t ever seem to exhaust themselves fretting if things will ever get back to normal. If there is a silver lining to social distancing it’s spending every day with the boys. It’s nice to watch them grow up.
When we build portfolios for retirement, for college, for a legacy, our investments experience plenty of setbacks too. Stock investing can be especially painful. After all, it is risky! A stock portfolio can be worth $100,000 on one day and drop down to $80,000 the next! But, like a skinned-knee, time heals stock volatility. It might just take a little longer.
Here’s what history has shown us
One way to understand stock risk is through our past experiences. The very long-term returns of stocks beat the very long-term returns of bonds* by a lot. To earn that return on stocks, though, you have to be willing to accept setbacks along the way. That’s why the stock line is not as smooth as the bond line (see below).
Source: CFA Institute. Stocks, Bonds, Bills, and Inflation (SBBI) Data. January 1926 to September 2020.
The idea that time makes stocks less risky is known as time diversification. Over longer periods, stocks generate more consistent outcomes and the risk of stocks starts to look like bonds, but with a much higher return.
So, if time reduces the irksome fluctuations that make stocks risky, and simultaneously creates substantially better outcomes, the next question is how long do we have to wait?
The answer (see below): about twenty years.
Source: CFA Institute. Stocks, Bonds, Bills, and Inflation (SBBI) Data.
Essentially, the longer the investment period, the better the chance of a good outcome. Investors need to buy and hold stocks for the long run. But, this is not true with bonds. Especially One-Month US Treasury Bills – it’s fairly certain you’ll get your money back. In full. Plus interest.
With time diversification, we can spread day to day volatility over long periods. The longer we own stocks the more consistent the outcomes and the more consistent the risk. Therefore, two things are generally true, 1) investors with long time horizons should mostly own stocks, and 2) over the long-term a stock portfolio should beat a bond portfolio.
So, if you can ignore the short-term noise and just focus on the next 20 years, own stocks.
A caveat when owning stocks for the long run
Having a long investment horizon makes stock returns less volatile on average. It does NOT, however, make the possible size of losses any smaller.
For example, when retirement planning you face a trade-off between investing aggressively and saving modestly or saving aggressively and investing modestly. If you invest aggressively, over a long time, you could build a large portfolio and then have huge portfolio dollar losses right before retirement.
Take two retirement planners. Both start saving $200 per month and investing for retirement on January 1, 1980. They both plan to retire 40 years later in 2020. One invests aggressively and owns only stocks, the other owns a mix of 50% stocks and 50% bonds and rebalances monthly. Let’s call the investors aggressive and modest, respectively.
Our aggressive investor will have amassed $1,444,000 by January 1, 2020 and our modest investor would have $514,000. The stock investor builds a portfolio nearly three times as large! However, during the COVID19 panic in early 2020, the aggressive investor saw their portfolio drop almost $300,000 (20% down) while the modest investor had losses of only $50,000 (10% down) by March 31, 2020.
Keep what you’ve earned
The good news is there is a way to enjoy the benefits of wealth accumulation and protect it. That technique is asset diversification. Before we consider asset diversification, however, we need to get wealth first. For most of us that means saving and investing diligently in stocks over the long run.
So, if we started early, saved often, and owned stocks we will likely end up with a big pot of money for retirement. Then we can choose to (or not) diversify with lower risk assets. What we’ve found is that as retirement nears, you don’t actually have to load up on lower risk assets, like bonds, because withdrawal needs are small in comparison to the size of the portfolio. Really, we only have to reduce risk for a small piece, leaving the rest to keep growing.
Good investment and retirement planning help investors account for shifting expectations and develop strategies to reduce risk. How your portfolio changes is dependent on how your unique circumstances change over time. Many prefer, though it’s not always necessary, to shift from stocks to bonds in retirement.
That last thing most clients want is to see their invested wealth get cut in half right before they retire.
Aligning investments to goals
Ultimately, investing in stocks for the long run helps to reduce average risk and increase average wealth. Time diversification encourages the ownership of higher returning stocks even though they are riskier.
Time diversification also has a dark side we can’t forget: the potential for much higher dollar declines. So, as we plan investment portfolios around future needs such as retirement, we need to stay aware of shifting preferences and how to weigh trade-offs. We all want large portfolios, but we don’t like large losses either. Think about it this way: a skinned-knee heals quickly, but a broken leg doesn’t.
As we develop solutions for clients, we need to continually make sure their money is aligned with what they want and they understand the trade-offs of choices being made. Smart investment planning makes this happen.
Adam K. Wright, CFA, CFP®
*In this instance bonds are being proxied by one-month US treasury bills. These are obligations of the US government that mature, come to term, and payback in under a year. There are no guarantees, and there are no true risk-free assets. One-month US Treasury bills are the closest thing we have to a risk-free asset.
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