“How much risk am I taking?” is the second installment in the “Rethink Investment” series. If you missed the first one, click here to read it.
Once we view our long-term investment as sharing resources before we need them, naturally we will ask next, “How do I make sure I can get my investment (and reward) back when I do need it?”
At the heart of this question is how we view risks. In modern day investment knowledge, risk is usually defined as the deviation from the expected return. For example, if you are a person that likes having a steady return year after year, you will hope that annual return over 10 years will be like the green line below – flat. However, the actual return will likely be lower or higher, and sometimes dip into the negative territory, like the red line.
For me, this way of looking at risk is not particularly helpful when you are investing for the long-term. We might get overly excited when the return is double our expectation one year, and be extremely mad when the return is negative in the next. However, you know that in real life investment returns fluctuate. Over a period of, let’s say 30 years, it is likely that the high and the low returns will average out, and the average annual return, taking into account compounding effect, will be closer to your expected return all along.
In fact, this is what happened in the US S&P 500, one of the longest running indexes in the world, which consists of large company stocks. With data going back to 1928, we can calculate annual return over periods of 5, 10, 20, and 30 years through different economic cycles and world events. This is shown in the graph below.
As you can see, the dispersion of return stretches way up and down when you are looking at the 5-year time frame, and gradually decreases to a small band when you look at the 30 year time frame. To make more sense of the return data, I adjusted it with inflation so the graph shows real return. The minimum real geometric return over 30 years is 4.3%, which is a pretty good number if you were originally afraid that you are going to lose money by investing in the stock market in the long-term.
This is not to say that in the future we will never have a period of 30 years that earn less than 4.3% real return annually. Nevertheless, this tells us, “It is likely that I can get my initial investment back, plus 4.3% interest per annum, in 30 years when I need to use it.” When you look at risk that way, you may have a totally different feeling about investing in the stock market in the long-term for your retirement, even though the TV is still blasting everyday that the stock market has rallied or tanked.
Of course, not everyone has a 30-year investment time frame, so using other types of investments, such as bonds, that have different patterns of deviation can help you bring in the upper and lower boundary of potential returns on your overall portfolio. This is what an effective diversification can do for you when you look at return in a shorter term, but that’s a discussion for another day.
Investing all of your savings in the stock market sounds risky, but when you do it at age 30 and do not expect to use it until age 60, maybe not so much. Is that a useful way for you to think about risk? What are your thoughts?