What’s Your Risk?
By Sam Swift, CFA
Volatility. Standard Deviation. Risk. You hear these words thrown around in relation to your portfolio all the time, but what do they really mean.
When the market is doing wonderfully we don’t necessarily think about volatility or risk but in reality, we are really experiencing the upside of volatility. A great bull market can be quite volatile using the true definition of the word, but of course we don’t think of it that way when it’s the right type of volatility. So as an investor, you’re really only concerned about the downside volatility when you talk about risk.
Let me illustrate what downside risk can mean and which timeframes are relevant to you. (By the way, all of the following numbers will relate to the S&P 500 Index as is standard practice thanks to the volume of data we have. Of course, as a client of TCI, you should keep in mind that the S&P 500 is just one piece of your overall portfolio. If you add in other asset classes and fixed income, the following numbers only get better.)
The financial media certainly tries to convince you that the market is extremely volatile on a daily basis and they’re not wrong. Going back to 1950, the S&P 500 has had a positive daily return 54% of the time—not much better than a coin flip if you were going to bet on it. The market is essentially a casino on a day to day basis. If you’re thinking you can possibly predict which of those days to be invested and which of those days to be in cash, you’re mistaken. But have no fear, because daily volatility has no bearing on your long-term plan. As you’ll see, the odds become increasingly in your favor as we extend our time horizon.
On a monthly basis, the S&P 500 had a positive return 63% of the time—better than a coin flip, but still no sure thing. Annually, there is a positive return 77% of the time. For all 5 year periods, a positive return happens 91% of the time. For all 10 year periods, we’ve seen positive returns 97% of the time. You can see where we’re going with this. You’re odds of a negative return get smaller and smaller the longer your time horizon becomes.
Let me repeat because this is important: Daily volatility is irrelevant to your long-term plan. Monthly and even annual volatility are fairly irrelevant to your plan. The only way it can be problematic is by causing panic which can then cause you to disrupt your long term plan. Remember that it is just noise.
Of course, this doesn’t tell the entire picture. Yes, 97% of 10-year returns are positive, but those returns can also vary widely. Even over 20, 30, and 40 year spans, a portfolio can range from keeping pace with inflation to doubling multiple times. Obviously, your personal outcome can be quite different in these two scenarios.
This is what we call generational risk and it is this risk that truly matters. Unfortunately, whether or not you’ve retired just before a 20 year relatively flat period in the market (1960) or an incredible 20 year bull market (1980) is all due to luck. Fortunately, you can control your behavior to help give you the best outcome with the hand you’ve been dealt. By managing your savings, your retirement date, and your expenses, you can limit the effect of generational risk and not let circumstances outside your power determine your financial success or failure.
So forget about daily volatility which is just noise you cannot control. The only risk that truly affects you is long-term generational risk and that can be managed and minimized with a well thought out plan.
The Risky Sport of Bubble Spotting
Carl Richards, NY Times Blog Contributor
During a recent conversation, someone asked me if I thought the last few years made me better equipped to spot the next bubble. Since we had recently been through a real estate and credit bubble could anyone credibly claim that they would be prepared to spot the next one?
My response was simple: no.
While the last few years hasn’t made me any better at bubble spotting, it has made me realize that when it comes to investing it’s truly better to be safe than sorry. For anyone who thinks that living through a market that clearly got ahead of itself somehow makes you better able to forecast the next bubble completely misses the point.
The supposed ability to spot bubbles is just another way of talking about market timing. Market timing, while not impossible, has certainly proven to be highly improbable.
It’s certainly tempting to believe that somehow we could identify a variable or series of variables that would tell us when the market was officially in a bubble. It reminds me of a conversation I had a few years ago where somebody who was clearly exasperated said, “All I want is for someone to tell me to sell before the market goes down and to buy before it goes up. Seems quite simple to me!”
Looking for a bubble spotter is just the latest way we’ve come up with to trick ourselves into thinking that there is a way to time the markets. We can get very sophisticated in the stories we tell ourselves. We look for things like quantitative models, advanced forecasting software, years of academic research and studies. But in the end, it’s all just market timing. And for the most part, it simply doesn’t work.
One of the big problems with some of the recent bubble spotting methods is that they work perfectly, just so long as you’re looking backwards. Many of these techniques are based on extensive research that relies heavily on back-tested models.
We are very good at analyzing the past and coming up with surefire ways of avoiding the exact same mistake again in the future. But what we are particularly bad at is thinking about things that we have never thought of before. Most bubbles are blazingly obvious with the benefit of hindsight, but when we’re honest with ourselves, we have to admit that often they were caused by things that we hadn’t even considered possible. And the exact cause of the next bubble will surely be different than the cause of the last bubble.
This current obsession we have with bubble spotting isn’t new. It’s just the latest reincarnation of the age-old desire we have to make sense of the world around us and have some sense of control about the future. But if we do want to use history as a guide, we need to realize that even those that were best positioned to spot bubbles have been wrong.
In July 2009, The Wall Street Journal surveyed 50 economists about where interest rates on the 10-year Treasury bills would be one year later. Rates were sitting at 3.3 percent when the article came out. Forty-eight respondents said they would be higher one year later, while only two suggested rates would fall below 3 percent. The rate was 2.95 percent on June 30, 2010.
And it’s not just in recent times that the bubble predictors didn’t get it right. As Jason Zweig recently noted in The Wall Street Journal, even the guy who wrote the most famous book about bubbles missed a big one:
On Oct. 2, 1845, [Charles] Mackay wrote that “those who sound the alarm of an approaching railway crisis have somewhat exaggerated the danger.” He went on to ridicule anyone who argued that “the Railway mania of the present day” was similar to the devastating bubbles he had described in his own book. “There is no reason whatever to fear” a crash, he concluded. He couldn’t have been more wrong. From 1845 to 1850, railway stocks fell by two-thirds — the equivalent of roughly $1 trillion of losses in today’s money. Mackay never fessed up to his own extraordinary delusion.
So back to the original question. If we’re not any more prepared to spot the next bubble than we were just a few years ago, then what?
The point is we should stop trying to trick ourselves into believing that if we just buy a bigger computer, hire the right analyst, find the secret newsletter and read enough magazines or books then we’ll somehow be able to buy before the market goes up and sell before the market goes down.
We need to give up on the idea of timing the market and finally pay attention to the academic research that shows it’s a fool’s errand. Instead we should devote at least some of that time to developing a financial plan that starts with where we are today and plots a course to where we want to go. Once we have built a plan, no matter how basic, then we can figure out how we need to invest our money to meet those goals.
TCI Shareholder Announcement
TCI is very excited to announce that, as of the first quarter of 2012, we have welcomed five of our team members as new shareholders in the firm. This expansion of the partner base within TCI is part of our continued commitment to our vision of building the ‘100 year firm’. We define that as operating a firm that will be here not only to provide our current clients with exceptional wealth management services, but will be sustainable beyond the tenure of our current shareholders in order to service our client’s children and grandchildren as well. This group of new shareholders brings a diverse set of expertise and perspective that further augments the resources and mindshare that is available to our clients. They also are a representation of the wide geographical footprint that TCI now encompasses with advisors from 4 of our offices being included in this group.
TCI Recent Events
TCI hosted Carl Richards, author of a new book, The Behavior Gap; How To Stop Doing Stupid Things With Your Money, at the Westward Ho. Clients who attended enjoyed an entertaining presentation coupled with appetizers and refreshments. They also received a complimentary copy of Carl’s book.
Doug Nelson in conjunction with another professional in Santa Fe hosted Weston Wellington from Dimensional Fund Advisors for a lunchtime event at the La Fonda on the Plaza in Santa Fe . The group of attendees enjoyed a wonderful meal as well as Weston’s presentation of “Redefining Investment Advice”