The following is a guest post by Mathieu Bouville.
Misconception #1: Risk is measured by volatility
Risk is a fuzzy concept. It is often equated with volatility, i.e. the tendency of the value of an investment to swing wildly: going from gains to losses and back again. But this cannot be a satisfactory definition: if you were promised that your investment would have a certain value on the day of your retirement, you would not care whether the value has gone up and down in the mean time. The real risk is: not having enough money when you retire. Not knowing whether you will end with $500 000 or a million is clearly better than the certainty of having $400 000.
Figure 1 shows that over thirty years a portfolio with 50% stocks and 50% bonds has only a 5% probability of gaining less than $50 000 out of an initial investment of $100 000 (the median gain is nearly $300 000, i.e. a quadrupling of one’s money). With a savings account, there is a 5% probability of gaining more than $48 000. In other words, what is a worst-case scenario for the stock-bond portfolio is a best-case scenario with cash. The portfolio is more volatile, but the savings account is the risky investment.
FIG. 1: The median and the top and bottom 5% of gains (after inflation) over $100 000 invested for 30 years. (Darker green bars have been truncated.).
Misconception #2: Savings accounts cannot lose money
If inflation is at 2%, what costs $1 000 now will cost $1 020 in a year. With $1 000 on a savings account yielding 0.5% p.a., you will have only $1 005 in your account in a year, so you will no longer be able to afford what you can now buy: you are losing purchasing power. The nominal rate of interest is +0.5% p.a. but the real rate is -1.5%. Accounts yielding less than the inflation rate reduce your purchasing power.
Savings accounts may seem the safest place for your money because you cannot lose the principal: worse come to worse you will simply not get any richer but you do not grow poorer by keeping your money in the bank. In actuality, the capital is not safe in real terms (i.e. when inflation is taken into account): your purchasing power may shrink with time. There is a genuine risk of losing money in a savings account.
Misconception #3: Risk taking is just a matter of personality
Risk taking is generally seen as essentially a matter of psychology: are you conservative or adventurous? Consider three thirty-year olds investing for retirement. One holds only stocks whereas another has 25% in bonds. The latter is simply more risk averse, this is just a matter of personality. But if the third were to keep all his money in a savings account for decades, this would not be conservative but downright stupid (see above).
How much risk you take depends on several criteria, and personality is just one of them:
- how much risk you can afford to take: e.g. if you will retire in one year then a market crash in the coming year would be horrible, but if you will not retire for decades it is much less problematic because there is ample time for markets to recover these losses;
- how much risk you need to take: if you started saving late and need a real return of 7% a year to retire then you cannot make do with a low-risk portfolio;
- how much volatility you can psychologically withstand: stock markets can collapse by a third from peak to trough — how well would you sleep if your portfolio fell this much? Pure equity portfolios may be best for long-term investors in theory but few people can stomach them in reality.
Misconception #4: The stock market is just like a casino
When markets crash, many Investors Anonymous swear never to touch a share again. Too dangerous, too unfathomable, too random. Investing is no different from playing roulette in the best cases, if not Russian roulette.
There is one very substantial difference though: for every $100 in bets, a casino may return $95 in wins, so that the more you play the more likely you are to lose. This is well known to casino managers: how to handle winners? Get them to keep on playing. The stock market, on the other hand, has an average return of 6-7% after inflation. The longer you participate, the more likely you are to win. The odd casino win does not cancel the fact that on average players lose. Conversely, market crashes do not cancel the fact that on average investors win.
This guest post was written by Mathieu Bouville, PhD, who uses quantitative methods for investment optimization at http://mathieu.bouville.name/finance/.
Risk is something I think about when I make my investment choices. My tolerance for risk is factored into my choices. Unfortunately, too many people do not consider risk. This is one of my reasons to invest some of my portfolio in mutual funds, because it spreads the risk more than individual stocks.
Well… No 2. I saw it first hand – inflation goes up, the value of money goes down and your $10 cannot pay for anything. No 4 – I have to admit that I am guilty of it. Sometimes I do think that way… not all the time, though! 🙂 Great post!
I think your point on the stock market is a bit misleading. That 6-7% figure is based on the past, and we all know past performance is no indicator of future. And a stock market crash CAN hurt, even if it’s the short term.
“That 6-7% figure is based on the past, and we all know past performance is no indicator of future.”
This is based on a century and a half worth of data; so for the next century and a half the number may be a bit lower or a bit higher, but it won’t be negative nor +15%. Historically bonds have never beaten stocks over a 20 year period in the US (25 years in the UK); yes in the future equity may underperform for a bit longer, but it will not underperform for 50 years all of a sudden.
Short-term past performance is no indication, long-term past performance is meaningful. Getting 3 ones in a row on a die tells you nothing on the next roll, whereas getting 25% ones over the long-term gives you information (if no certainty).
I don’t know that #2 is such a misconception these days. Inflation is very much on people’s minds, especially at the grocery store. They may not know the *how* and *why* of inflation, but they know that even their savings are eroding away, little by little. All it takes is having experienced one massive haircut in the market, and savers may choose the water torture of savings erosion over another 40% dip.
I always think of the risk when i consisder investing and weight it against the gain if the odds are favorable i invest.
On number 4, Buffett continues to prove that it’s not a casino. Either that or he’s the luckiest guy in the world 🙂
Very nice post!
I think tip #2 should be blasted right across the front page of the Wall Street Journal. There are so many people who just don’t seem to realize this!
Great post. 🙂
Very true on the savings account. Some people do not realize that by investing in the low yield savings fund alone, they are actually losing money because of the effect of inflation. The risk of losing the purchasing power of your money is a big risk that cannot be ignored so the key is to really diversify the portfolio when investing long term.
Great post. These really are some of the top misconceptions on investing. Some people consider the stock market to be risky, so they never invest any money in it. But, if they keep their money in a savings account, they are risking a poor retirement, or never retiring at all!
Nice post. I agree there are many misconceptions about risk and I believe they should be kept in mind when the advisor pulls out the “risk tolerance” questionnaire. One thing for investors to keep in mind is that our perceived risk tolerance depends a lot on recent performance. Today is an excellent example. Investors are gun shy after 2008.
On the volatility issue there is a risk, broadly speaking, on both the upside and the downside. In 2000, after 4 spectacular years many investors ( I use the term loosely) made horrendous mistakes by overweighting the internet sector and stocks in general.
Again, nice post – a subject that deserves a lot more discussion than it gets.
#4 is true, but also not true. Many people go into casino’s not having a clue what they’re doing. The same goes for the stock market, so you could say that the stock market is like a casino. For those who are educated and trading with knowledge, the stock market is far from a casino.
“Many people go into casino’s not having a clue what they’re doing. The same goes for the stock market, so you could say that the stock market is like a casino.”
You don’t need a clue, you need patience. Play in a casino for 30 years and you are very very unlikely to win money. Invest in stocks and bonds for 30 years and you are very very unlikely to lose money.
Great post! Risk is such a complicated subject. The way you look at the saving account is quite different. It all depends on your time line I suppose. If you have a year before retirement, the saving account is a lot less risky than the stock market.
Of course some people jack up the risk by using margin accounts, option trading, day trading and more.
Great post Mathieu! #2 seems like a no brainer for us personal finance writers, but it’s surprisingly scary how much money people have in low (to no) interest bearing savings accounts. Even if your personality is low-risk, you still need to understand that your money is losing value to inflation.
Nice post.
On misconception #3, you could have added a bullet “How much of the risk you are taking can you mitigate?”. For instance, if you have decided to purchase tax lien certificates to take advantage of the high rates of return they offer, have you spent the time needed to investigate the properties which secure the lien you want to bid on? Do you have enough emergency cash to cover the period for which your money will be tied up in the tax lien certificate and etc.
“There is one very substantial di fference though: for every $100 in bets, a casino may return $95 in wins, so that the more you play the more likely you are to lose.” – this is true is you’re playing roulette. But if you play blackjack and know how to count cards, you will be beating house advantage and more you play more chances you have. The same with stock market, just think “counters” in blackjack = “educated and trading with knowledge” (Jeff) is stock market.
Another similar think, casinos have special rooms for rich players and have better rules for tham (with lower house advantage), same with stock market, “the big” people will always have advantage over you.
As per Saving accounts…you are right if you’re talking about 0.5% interest, but even now you can have 2% interest in ING for example.
GIC is another story….now they are bad, but when I came to Canada in late 1999, I was buying 3 months GICs and receiving 4.5 – 4.75% interest! and for a longer term it was even high. Give me this interest now, I will sell majority of my stocks
“As per Saving accounts…you are right if you’re talking about 0.5% interest, but even now you can have 2% interest in ING for example.”
Inflation in the UK is 4%: good luck beating that with a savings account. Also bear in mind that rates are typically gross, so beating even low inflation after tax can be tricky.
This was a good post. I wonder what the results would have looked like if a 60% stock, 40% bond portfolio was rebalanced annually. From about 1990 to today, my guess is that it would have done much better than a 100% equity portfolio. If it was from 1982 to 2000, it would have been crushed. I guess there’s no real way of knowing in the future, is there? Rebalancing does allow you to be greedy when others are fearful. And if you can do it when markets really get hammered, you can make a killing with bonds in the portfolio—allowing for plenty of dry powder when things get cheap. Great post. Loved the charts.
* If you love charts, look at http://mathieu.bouville.name/finance/
* “I guess there’s no real way of knowing in the future”
I cannot tell you what exactly will happen, but there is something to say about how likely various outcomes are, even without knowing the future.
Interesting post! As I quote Mark Twain “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
#2 is my favourite. People tend to forget that not keeping up with inflation is, in fact, losing money.