Are we looking at risk the right way?

Sam Swift

Sep 4, 2014

By: Sam Swift, CFA, CFP®

The financial industry does a poor job of properly defining risk. For example, you ‘ve probably seen standard deviation as a proxy for risk when looking at past performance of a portfolio, but what exactly does that mean? Even if you’re able to recall what you learned in that sophomore year statistics class, you’re still probably at a loss for how that helps you make a good decision. Sometimes you get a chance to see the best and worst historical returns; this at least gives you a better sense of the extremes in portfolio volatility, but still comes with issues.

The big problem is that the financial industry constantly stresses the importance of long-term returns, but then reverts to short-time periods when trying to define risk. To be fair, there are some valid reasons to emphasize this short-term definition of risk and they’re primarily based on investor behavior—namely, if an extremely negative year or two causes you to bail on a portfolio all together, then you’re never going to realize the associated long-term returns. Nevertheless, this focus on short-term volatility as the true measure of risk can do more harm than good especially in the case of an investor with a longer time horizon.

Below, you’ll see a chart that shows three different portfolios ranging from “safe” (100% Fixed Income) to “risky” (100% Equity). I went back 80 years in the data to pull out the average, best, and worst historical results for different time horizons.

September 1st image

Now, in 1-, 5-, and even 10-year periods it may be very comforting to know that even in a worst case scenario the 100% fixed income portfolio would remain basically flat. With a 100% equity portfolio there’s no guarantee that you’d have more money than you started with over those time frames and in the case of 1- to 5-year time periods you could have significantly less. Thus, if you’re going to need the money you’re investing in a relatively short amount of time it likely doesn’t make sense to invest that in a volatile portfolio. Of course you should expect less return on average, but that’s the price you pay for eliminating the catastrophic scenario.

As a young investor (or anyone with a longer time frame for their investments—think of a retiree who wants to leave an inheritance, for example), a focus on short-term volatility can be counterproductive. As you look at the longer time frames you start to see the best and worst case scenarios converge towards the average. In fact, at 15 years the absolute worst historical case for the “risky” all equity portfolio nearly outperformed the average historical case for the “safe” portfolio! Your real risk in this situation is letting the threat of short-term volatility push you away from the opportunity to capture long-term returns.

To emphasize the point here’s the same chart as above, but converted into dollar terms. This assumes you started with $100,000 in your portfolio and presents the value in today’s dollars by accounting for a 3.5% inflation number. The real price you pay for avoiding short-term catastrophe is the difference in long-term dollar values—the average result for fixed income barely keeps up with inflation!

September

When you look at time horizons longer than ten years, the “risky” portfolio is in fact the safest option.

 

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