This is the first post in a series of three on on the factors that determine how much we can expect to make from investing. How our risk tolerance affects our returns is covered in this post, and it’s this, combined with how long we invest for, and how much we pay for our investments, that determines our ultimate returns. For an overview of all the posts on this blog, please refer to the guide.
George Maddox served as a plant manager for 30 years at America’s fifth largest company. He saved diligently into the company’s pension plan, making contributions into the company’s employee stock plan every month. Upon his retirement, his pension was worth $1.3m. Unfortunately, the company he worked for was Enron, and upon their bankruptcy in 2001, his pension pot went from being worth $1.3m to under $4,000. George’s retirement savings were decimated and, now retired, George had to resort to mowing lawns to make ends meet, whilst his wife had to return to work as a substitute teacher.
Lou Pai also worked at Enron as the CEO of the Enron Energy Services division, and also had much of his net worth tied up in Enron stock. After getting a stripper pregnant, his wife filed for divorce and he was forced to sell his shares in Enron. He cashed out his shares before the company went bankrupt, when they were worth over 200 times what George sold his for. He later left the company with over $280m and became the second largest landowner in Colorado.
The contrasting stories of George and Lou serve as a perfect lesson in risk. Both took a massive risk in investing their wealth in the stock of a single company. Because of the size of the risk, the outcomes were binary. One made a fortune, the other lost it all.
The art of investing is balancing the need to take risk in order to generate higher returns, against the idea that taking too much risk can lead to heavy losses.
Risk means different things to different people, and there’s much debate in the investment world about what risk actually means in an investment context. Some think it’s the magnitude of fluctuations in your portfolio value (volatility), some think it’s the risk of a permanent loss of capital, and still others think it’s the risk of not meeting your goals. Whatever your preferred definition of risk, it’s universally accepted that risk plays a crucial part in determining your returns – you cannot earn high returns without taking on risk.
As we saw in my last post, cash is extremely safe in the bank, but offers a low rate of return. Higher risk investments will likely offer higher returns over the long run, but they are also more likely to fall in value over the short term, and suffer larger losses along the way.
The law of misleading averages
Rightly or wrongly (I’d argue wrongly), one of the first thing investors tend to look at when deciding whether or not to invest is the investment’s past performance. Often this will be quoted on an annualised basis over 1, 3, 5, and 10 years (the average one-year return over these time-frames) versus some sort of benchmark. What an average figure hides, though, is how different the actual returns have been compared to the average – i.e. how risky the investment is. Taking the S&P 500 for example (which I’ve chosen as it has historical data for both stocks and comparable bonds going back all the way to 1927) its calendar-year returns compared to its average return are shown below:
The S&P has an average annual return of 9.7% per year (in $ terms), but has on occasion had returns of over 50% in one year, and has also had returns of -40%. You can see from the graph that it’s incredibly rare that the S&P’s returns have even been close to its average. In fact, only 19% of calendar year returns since 1926 have been within 5% of the average return (i.e. between 4.7% and 14.7%).
If we compare the S&P data above, which would be considered a higher-risk investment (as it’s 100% equity), to a low risk investment in US 3-month T-bills we can see that the results are quite different:
The lower risk investment has a lower average annual return of 3.4% per year, but the variation of returns is also much lower. For T-bills, 93% of returns are within 5% of the average, compared to the S&P’s 19%.
Understanding standard deviation
One popular way to understand how volatile an investment is, is to look at the standard deviation of the investment’s returns. Standard deviation is a measure of how spread out the investment’s returns are, compared to its average (also known as the “mean”) return. An investment with a high standard deviation will have more returns that are further away from the average, and an investment with a low standard deviation will have returns that are closer to the average.
Standard deviation can be viewed visually in bell-curves (aka a “normal distribution”). The below graph shows 2 investments, both with the same average return of 5%, but one with a standard deviation of 5%, and one with a standard deviation of 10%:
As we can see, the standard deviation indicates how many of the historic returns lie close to the average. A low standard deviation means returns will likely be close to the average, and a high standard deviation means returns are likely to be further from the average.
As standard deviation can be measured on differing time periods (it can be daily, monthly, quarterly, etc), an annualised standard deviation measure is known as volatility. To offer a more like-for-like comparison against other investment products, it is this number that most investment factsheets will show.
The risk spectrum
Obviously the choice of investing in either a risky asset or a less risky asset is overly simple. As long as we have the option of investing in a low-risk asset and a high-risk asset, we have the option of blending them to suit our risk appetite. One of my favourite ways to think about increasing risk levels is through the following chart:
We can see that blending high risk investments with low risk investments gives us a number of risk/return options. The graph above uses the US stock and bond data, and we can see that investing in a low risk portfolio of 100% T-bills gives us low return, with a low chance of either a very high return or a very low return. Most returns fall into a narrow band around the median return. Investing in a high risk portfolio of 100% US equities gives us a higher return, but with a higher chance of either a very high return, or a very low return. Most returns fall into a wider band around the median.
The difference between the highest return and lowest return increases as you go up the risk spectrum, as does the range for the majority of returns. But then as risk increases, so does the average return.
So why is risk bad?
If we know it’s is necessary to secure high long-term returns, why is volatility a bad thing? Why can’t we just invest in high risk assets, sit back, accept the volatility, and reap the rewards? There are two answers – 1) our time-frame, and 2) our own behaviour.
Investing in more risky investments is rarely a good idea if you intend to withdraw the money invested in the short term. What constitutes the “short term” isn’t exactly scientific, but most people use a 5 year time horizon as the minimum before adding much risk to a portfolio. Investing in risky assets over a short time horizon means running the risk of having to withdraw the cash after the investment has suffered a large loss, without giving it time to recover. This is more likely the more risky the investment is. Risk can be dangerous over a short time frame.
Even over the longer term, risk can be dangerous. When it comes to investing decisions, we are our own worst enemy – and this is particularly true when we invest in volatile investments. Volatility makes an investment much more difficult to stick with over the long term. It is an uncomfortable feeling to watch a portfolio fall in value, as you never know when the fall will end. It’s very easy to look at graph of past returns and assure yourself that you would’ve held on during the crashes because of the fantastic subsequent returns. But when faced with the reality, watching your investments start to lose value and not knowing whether the loss will stop at 30%, 40%, or 50% makes logic pale in comparison to our need to make the bad feeling go away. We do not have the crutch of knowing, as we do when looking at past returns on paper, that the losses will stop and gains will eventually follow. As far as we’re concerned, the losses feel like they could go on forever, and we need to take action to stem the bleeding.
What would you do if you watched your portfolio fall 50%? The temptation is, in the face of our investments losing value, to do something – to do anything. Doing something feels better than doing nothing, because then at least the feeling of losing money is mitigated by our efforts to stop the losses. We feel an urgent need to make the red numbers go away, and are willing to weave any sort of narrative in our own heads to justify our actions. When it comes to losses, we stop acting rationally. It’s been shown that investors dislike losses twice as much than they like the equivalent gains – something known as loss aversion. It is this disproportionate aversion to losses that makes them feel so painful, and causes the overwhelming urge to sell.
In reality, it’s exactly this behaviour that causes investors to sell their investments at their lowest point, the point of maximum emotional pain, and buy something else. The irony is that not only are we likely to sell at the worst point, the replacement investment is often bought due to its recent strong performance, which in turn makes it more likely to suffer at the hands of another law of investing – mean reversion – and subsequently fall in price. This all feeds in to an investing phenomenon known as the behaviour gap, which is the tendency for investor returns to be reduced as a result of their own behaviour.
It’s this emotional pain caused by volatility that is price we pay for long term returns. If capturing high returns was easy, everyone would do it, and the returns would cease to exist. The financial blogger Morgan Housel put it eloquently when he said, “Returns do not come for free. They demand a price, and they accept payment in uncertainty, confusion, short-term loss, surprise, nonsense, stretches of boredom, regret, anxiety, and fear.”
So how can we combat this fear, and stop ourselves from selling at the wrong time?
Much of the work on reducing behavioural risk can be done before we actually invest. By ensuring we are not taking on more risk than we are comfortable with before we invest, we reduce the risk that the portfolio falls more than we’re comfortable with in the future. Exactly how much risk we should be taking on is an intensely personal decision, and depends on a multitude of factors personal to us, our financial situation, and our attitude towards losses. If an investor were to use a financial advisor, it is the financial adviser’s job to work out how much the investor can afford to/needs to invest, and give the investor a “risk tolerance” questionnaire which works out how much risk the investor should be taking. This then determines the asset allocation in their portfolio.
For those of us interested in investing without the use of intermediaries, there are a number of risk tolerance questionnaires available online which serve as a good starting point. To get a “back of the envelope” idea of your risk tolerance, another good starting point is to have a look at the historic maximum losses incurred by your potential investment (ensuring the returns cover a long enough time period to capture some market crashes), and ask yourself whether you’d be comfortable with losing that amount of your portfolio, and whether it would affect your lifestyle. Remember, as mentioned before, it’s always easy to deal with losses in theory, looking backwards and knowing that the investment has later rebounded. It’s much more difficult to deal with losses in real life. As an illustration, the graph below shows the maximum drawdowns (maximum losses) of various combinations of the S&P 500 and a 3 month treasury:
If you’re interested in how your “risk tolerance” is calculated, it’s made up of 2 factors – your willingness to take risk (how happy you are to accept losses in the hope of longer term gains), and your ability to take risk (how much a loss in your portfolio would affect your financial goals). In general, your risk tolerance is set at the lower of the 2 – someone with a low willingness to accept risk, but high ability would be a ‘low risk’ investor, as would someone with a high willingness, but low ability.
Tailoring our asset allocation to our risk tolerance before we invest is a vital first step in ensuring we can stay the course and avoid selling at the wrong time.
Once an investor has decided on a suitable portfolio based on their risk tolerance, this is where the really tough decisions come. There will always be times where the portfolio loses money (as long as some risk is taken), and the decisions that occur during periods of drawdown are critical for the portfolio’s long term returns. Deciding whether to make a change or stay the course following a loss is one of the most important decisions an investor will have to make. However, making the rational decision during a sea of red numbers on a valuation can be incredibly difficult to do. To help with this decision, I’ve dedicated a post to this very issue.
An interesting thought on investment risk is that, like energy, risk can neither be created nor destroyed – only transformed. By reducing the level of volatility in our portfolio by allocating more towards less risky assets, we reduce the risk that our returns will be volatile. But at the same time we increase the risk that we fail to meet our investment goals, as these lower risk investments provide a lower return. We have transformed the risk of volatile returns into the risk of not meeting our goals.
Thinking of risk in this way enables us to understand that risk in a portfolio is inescapable – it is just a matter of how we choose to embrace it. It’s therefore crucial for us to ensure we understand how we are taking risk in our portfolio, and that our asset allocation remains appropriate on an ongoing basis.
How can I ensure my portfolio’s risk remains appropriate?
A portfolio’s risk is not a static number. As markets move, so does the risk of a portfolio. If, for example, an investor starts off with a 60% equity, 40% bond portfolio, which is aligned with their risk tolerance, the more returns the investor enjoys from the market doing well, the larger the equity weight becomes, and so the more risky the portfolio becomes.
To help ensure the risk of a portfolio remains appropriate, investors should:
- Stay diversified. By asset class, geography, sector, currency, and time. Diversification helps reduce portfolio volatility by investing in assets/geographies/sectors/currencies that go up when other parts of your portfolio go down. These are called negatively correlated returns. Diversifying through time by drip-feeding money into the market through regular contributions also adds to the diversification benefit and can reduce the risk of investing right before a crash.
- Review personal circumstances. Investors should periodically review their Investment Policy Statement, and update it for any changes. Most people, including the regulator, recommend reviewing your IPS at least once a year. Both your willingness and your ability to accept risk may change over time, so it’s important to keep your IPS up to date. There are any number of additional factors that can affect an IPS (and therefore a portfolio), so periodic reviewing ensures an investor’s investments are always appropriate.
- Rebalance. Periodically review the portfolio to ensure that it is still in line with the target weights and rebalancing rules dictated in the IPS. By trimming the best performing assets and adding to the underperforming assets, an investor ensures the level of risk taken stays appropriate.
Investment risk can never be destroyed, only transformed – owning stocks is risky in the short term, but not owning them is risky in the long term. Embracing risk within a portfolio can feel painful during periods of drawdown, but risk is necessary to earn long-term returns. It’s vital that the level of risk we take within our portfolio is appropriate for our risk tolerance and return objectives, that we understand the emotional pain that additional risk can inflict on us, and that the risks in our portfolio are adequately managed on an ongoing basis.
As mentioned in my previous post, risk is only one determinant of our ultimate investment returns. Returns are also dependent on the level of fees paid, and the time for which we’re invested. Click here for the next article in the series, on time.