The biggest risk in investing is that your money won’t do its job when you need it to. Forget nominal guarantees and volatility, and focus on meeting your financial objectives.
A key concept in investing is that you need to take on more risk to get more return. This is such a fundamental truth that it’s considered an essential part of an investment offering. Here’s an example chart from a Vanguard fund page.
Many people look at this, make a decision about what level of “risk” they are willing to take, and start investing.
However understanding what this risk means, and how and when it applies to you, is perhaps the single easiest way to improve your investment performance. Because the risk shown here is likely not the risk that matters to you. And also, there are other non-risk characteristics that can matter a lot in terms of meeting your investment goals.
Here are a list of risks to consider for your investments.
Risk #1 The risk of losing your nominal principal. This is the reason banks have been making a killing off of you for years. In simple terms, banks guarantee that you will have at least the amount of your initial investment there when you come to get the money back. You put in $10,000, you’ll get at least $10,000 back when you come visit us! A total guarantee, or at least so it seems.
We are programmed by nature to absolutely love this version of the investing game. It turns out we hate “losing” so much, that we are willing to give up a ton to insure it. There’s a name for this tendency - loss aversion – there are even charts showing it, like the one below:
Simply put, we emotionally suffer from a 5% loss many times more than the pleasure we feel from a 5% gain and make bad decisions because of it. It's literally ingrained in our brain to hugely overvalue a nominal guarantee. And it turns out that for high yield savings and similar instruments, the price of this nominal guarantee (the feeling that we are always winning), is that – we are always losing.
Why? Think of investing as a bunch of games at a casino with different rules and payouts. (In fact, investing is somewhat like a casino or carnival, except the odds are stacked in your favor – we’ll cover that another time).
The game you are playing with the bank/casino involves giving them your chips, and being able to request at least that number of chips back whenever you want. Seems like a win, but we must consider the problems of TAXES and INFLATION.
Taxes is like a guy at the door of the casino on your way out who taps you on the shoulder with some bad news. You came in with 10,000 chips, and are trying to walk out with 10,200 chips – he looks at those 200 chips “profit”, and takes his share (up to 100 of your chips, depending on where you live). You simply have no choice in the matter.
If this is all that happened, the game would still be pretty attractive to the loss aversion crowd, because you’d still always be walking out with more than you came in. But there’s another vicious part of this game.
When you go to cash the chips, they aren’t worth what you paid for them. Whether you were in the casino for one minute or three years, your chips are going to go down in value - Instead of getting $100 for the red chip, you get $99. Or $98. What happened? You can’t buy the same stuff you used to be able to with your 10,000 chips. This second peril is called “inflation”. Your money is simply worth less over time because prices constantly go up.
So we encounter one of the most important lessons in investing – don’t overpay for nominal guarantees.
Risk #2 – volatility. This is the one academics love, and it is a somewhat better definition of risk. What this means is that, the more an investment zigs and zags over time, the more return you should get for that investment.
Some numbers might help show this:
Short term bonds have a “standard deviation” of 3.12% with an average return of 5.89% since 1972. That means that 68% of the time, they should return within 3.12% of 5.89% - or between 2.77% and 9.01%. You’re pretty likely to get a positive outcome but over time you’ll get lower returns than more volatile investments.
Stocks have a standard deviation of 15.07% with an average return of 11.13% since 1972. That means that 68% of the time, they should return within 15.07% of 11.13% - or between -3.94% loss and 26.20% gain. All over the map, but much more impressive long term results.
This volatility definition makes intuitive sense – the less certainty that you have of getting a return, the more you should get paid to take on that uncertainty. If you own stocks, you might go years without getting your money back! This is why you might have heard the common advice that you should not invest in stocks if you need the money within 5 years*. With all the zigging and zagging, you just don’t know with much certainty what’s going to be there when you go and get it.
It turns out there is a flip side to this volatility. If you are investing a consistent amount of money every month over a long term, you will typically accumulate more shares as an investment gets more volatile. The reason is that you will end up buying more when the asset is cheaper and less when the asset is more expensive. Let's look at this in chart form comparing two 7% investments. One returns 7% every year, the other a volatile stream with a long term return of 7% per year. In both cases we invest $10,000 the first year, and then 2% more every year.
You made an extra 10% by consistently investing during the period.
*I disagree with this overly broad conclusion, because stocks can sometimes mute the volatility of a portfolio.
Risk #3; The risk that it won’t be able to perform the job it needs to.
We spoke earlier about dividing your money into buckets and giving each bucket its job. For the sake of an emergency fund or spare cash, you don’t know when you’ll need the money, but you do know that you want it to protect your purchasing power after taxes and inflation regardless of when you need it. The fundamental risk you have is that the money needs to be able to purchase what it's supposed to when you withdraw it.
Therefore, unlike the common advice to invest your emergency fund in high yield savings or similar nominally protected accounts which are pretty much guaranteed to not do this job, we recommend the ULP – a blend of 88% intermediate term bonds and 12% stocks. I like it so much, I wrote a book about it with Shannon Matthiesen.
A related risk exists for your retirement bucket. Since the job of retirement is to provide a stream of income for an unknown duration at a relatively known date in the future, typically you need to invest in far more volatile/high growth investments. Since you don’t need the money for many years, you are able to withstand even multi-year periods of poor performance in order to get the greatest long-term gains and the greatest ability to pay you that stream of income when you’re ready for it.
The biggest mistake people make for retirement? Not taking on enough growth and volatility and therefore not having enough money in retirement.
Risk #4 – you underperform for emotional reasons. Study after study shows us that people panic when investments go down and sell at the bottom – the exact opposite of what they should be doing. Any plan that you are not fully committed to, regardless of short term losses or gains, WILL not perform over time. Investing is about coming up with a system for investing each bucket for its job, and then trusting that system.
In fact, the average investor does worse than the market by about 5%. Check out a recent study here https://www.thebalance.com/why-average-investors-earn-below-average-market-returns-2388519
~5% may not seem like much…but it is in fact, everything. In fact, the performance is roughly the difference between the safe short term bonds we showed above, and being totally invested in the stock market. In other words, most people suffer all the heartache, volatility, and timing issues of stocks – but get returns that equal…stable, short term bonds.
So here’s the practical advice:
1) Divide your money into buckets
2) Understand the job of each bucket
3) Define an investment system for each bucket that maximizes the probability of doing the job for that bucket
4) Be prepared for the volatility of how each bucket performs
5) Stick with it