Investing Risk Re-defined
As the stock market reaches new highs we will start to hear pundits recommending to all who will listen: Get out of “risky” stocks and into “safe” investments (meaning bonds, CDs, Money Market accounts, etc.). Unfortunately the perception of many investors, reinforced daily by the financial press, is that risk is defined by the volatility of stock market prices. While it is true that stock market prices can be very volatile, risk and volatility are not equivalent, and this misunderstanding is the downfall of many an investor.
So let’s unpack this risk thing a bit. First, a very real risk facing any investor is inflation. Yet moving out of stocks into “safe” investments actually exposes the investor to much greater inflation risk, and the numbers are shocking. Let’s look at some data. From 1926 through 2013, the average annual returns of market indexes, assuming reinvestment of dividends, were:
|Large Company Common Stocks||10.1%|
|Small Company Common Stocks||12.3%|
|Long-term, High Quality Corporate Bonds||6.0%|
The problem with inflation is that it eats into these returns with a vengeance, and the Consumer Price Index over that same period compounded annually at 3.0%. So the real returns, adjusted for inflation (the resulting earning power of those dollars) were very different:
|Large Company Common Stocks||7.1%|
|Small Company Common Stocks||9.3%|
|Long-term, High Quality Corporate Bonds||3.0%|
To put this into real dollar terms, an investor who invested $200 per month over a 40-year working career and experienced the returns these three options provided would have an ending value of:
|Large Company Common Stocks||$547,732|
|Small Company Common Stocks||$1,007,883|
|Long-term, High Quality Corporate Bonds||$191,624|
Ouch! Obviously there is an extreme price to be paid for having “safe” investments, and you ignore inflation risk at your own peril.
Now there are other risks to owning stocks that must be understood and managed. Investing in individual companies carries the business risk that even the “best” companies may fail, and stockholders may lose everything. But that risk is easily managed by diversification, and that is why I personally own a (very small) piece of more than 12,000 companies, so if one falls on hard times, it is of little consequence to me.
Finally there is the market risk that the stock prices of all companies fall, and the current market value of even a diversified portfolio goes into the tank. In fact, since 1980, the averageintra-year decline in the S & P 500 index, for example, has been 14%, and over the course of a full year we have seen declines approaching 50%. That’s called price volatility, and it is real.
But volatility equals risk only if you have to sell! Stock prices have fallen many times in the past, but the key fact that many miss is that while prices go down, they have never stayed down. So if you don’t have to sell when the market is down; if you can be patient and wait until the prices recover, you will have lost nothing due to market risk.
That is why the financial planning process is so important. If you know what your needs are in the relatively short term, you can accept some inflation risk (by putting that money into CDs or Money Market accounts), but not take major business or market risk. Then that money (while perhaps making only a modest return) will be there when it is needed.
But if you don’t need the money for some time (five years or more), you don’t really need to be concerned about the volatility of your investments, because you can wait to sell until the market recovers. As Warren Buffet is so famous for saying: “The stock market is very efficient in taking money from the impatient investor and giving it to the patient investor.” That patient investor should be you!
Emerson Hartzler, MBA, is a Lakeview Village resident, and, though he lives in a retirement community, he continues working as a financial advisor for Triune Financial Partners, LLC, at Lighton Plaza, 7300 College Blvd., in Overland Park, Kan. Reach Triune at 913-825-6100.