- One of the most common perceptions
about investing is that it is risky.
That is a statement that is easy to make
but hard to defend when you get into the details.
To decide whether or not investing is risky
we first need to think about what risk is.
Depending on what you are investing in
and what you are investing for,
there are different ways to think about and measure risk.
In broad terms,
risk in investing comes down to the risk
of future consumption.
Will investing today meet your consumption needs tomorrow
or in 30 years?
More specifically,
the most important risks
that every investor needs to understand
are total loss, volatility, uncompensated risk,
skewness and inflation.
I'm Ben Felix, portfolio manager at PWL Capital.
In this episode of Common Sense Investing,
I'm going to tell you which risks matter
when it comes to your portfolio.
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It is common to think about risk in terms of total loss.
You invest your money in a stock,
things turn sour, and it's gone.
This can happen when you invest in a single stock,
but when you really diversify your investments,
it is much less likely.
For an entire stock market,
and the index tracking it to deliver a total loss,
we would be talking about a true economic catastrophe.
Even if this did happen in one country,
it is unlikely that it would also happen
in all of the other countries
with functioning public stock markets.
For a properly diversified investor,
the risk of a total loss is very low.
At least as long as capitalism continues to function.
Even for a well-diversified investor,
volatility is not a risk that will go away.
When most professionals and financial product manufacturers
are talking about risk,
they're talking about volatility.
Volatility is a measure of the variability in returns.
A highly volatile investment would be expected
to have big ups and big downs.
Volatility is scary for humans.
Watching your investments skyrocket and then plummet
is stressful for a lot of people.
But is volatility a risk?
Well, it depends.
If you were investing money that you need tomorrow,
then volatility can materialize as a real risk.
In a 2018 essay in a financial analyst journal,
titled "Volatility Lessons",
Eugene Fama and Ken French constructed a statistical model
to examine the probability of negative risk premiums
over various time periods.
For the equity premium, that is the return of stocks
in excess of the return on risk-free investments,
they found that over a one-year period
there might be a 36% chance of stocks making you worse off
than investing in risk-free investments like treasury bills.
This figure is roughly in line
with historical one-year periods
across global stock markets.
The real kicker in terms of volatility being a real risk
for a short-term investor
is that in some cases those single year losses
can be substantial.
If you're investing money that you need in the short term,
I would say within five years,
then he is an extremely important measure
for assessing the riskiness of an investment.
For example, an investment in stocks would be far too risky
due to its volatility
for money that you will need to use
within the next five years.
Even an investment in bonds could be too volatile
for a very short-term need.
Whether or not volatility is a real risk for you
depends on two things.
Your time horizon
and your psychological tolerance for volatility.
If you have a long time horizon and a strong stomach,
then volatility is less relevant.
But it still can't be ignored.
Even over longer periods of time, Fama and French found
that it should be possible.
for stocks to underperform risk-free assets
Over 100,000 simulated 30 year periods,
they found that there was still a 4.08% chance
of a negative equity premium.
This is one of the most interesting insights
from their essay
because there are very few 30-year historical periods
that we have to observe in the real historical data.
One important note about Fama and French's method
is that it ignores any auto correlation in stock returns.
Historically, periods of negative stock returns
have generally been followed
by periods of positive stock returns.
Whether or not we should rely on this type of mean reversion
in estimating future outcomes is an academic debate.
For our purposes, I think that it is safe to say
that due to volatility, it is possible though unlikely
for stocks to deliver a negative return premium
even over very long periods of time.
In general, a more volatile investment
will have a higher expected return.
This means that for a long-term investor
with the emotional fortitude to ride out volatile markets,
a more volatile investment, like stocks,
might deliver a better expected outcome
than a less volatile investment, like bonds.
An important nuance here is that volatility alone
does not indicate higher expected returns.
It depends on what is driving the volatility.
There are two main types of risks
that affect the volatility of an asset.
They are compensated risk and uncompensated risk.
Compensated risk is a systemic risk
that the market prices into securities.
Stock prices are theoretically
the discounted value of future earnings.
Taking on compensated risk is sensible.
You are buying future earnings at a discount.
The discount is where the compensation comes from.
More compensated risk
means a deeper discount on future earnings
which means a higher expected return.
Uncompensated risk is a very different.
It is the risk specific to an individual company,
sector or country.
Maybe the visionary CEO ate some bad tuna
and started making questionable decisions.
A sector is disrupted
or a country is affected by climate change.
A good example is the change in sector composition
from 1900 to today in the U.S. and UK markets.
Maybe a big bet on tech today is
like a big bet on railroads in 1900.
This random risk can materialize at any time.
When you're properly diversified,
this type of risk can be almost completely eliminated.
Any time that you own an individual stock
or bet on a sector,
the uncompensated risk is always looming.
You might still benefit from compensated risk,
while owning an individual stock or sector
but the uncompensated risk specific to that asset
could easily and unexpectedly
dominate your ultimate outcome.
All right, so far we have covered total loss
and volatility as risks.
In the short term, volatility is a very real risk.
In the long run, it is less of a concern,
but can't be entirely ignored.
We've also broken down the drivers of volatility
into compensated and uncompensated risk.
Owning a single volatile tech stock does not mean
that you have a high expected return,
because the volatility is likely being dominated
by asset specific risk,
which is not compensated.
On the other hand,
owning a diversion justified portfolio of stocks
effectively eliminates the specific risk
of any one company or sector
leaving you with a compensated risk of the market.
Concentration in a small handful of stocks
is risky for more than one reason.
There is a statistical measure called skewness
that looks at how outcomes are distributed
relative to a normal distribution.
A normal distribution would see similar amounts of outcomes
with similar magnitudes on both sides of the distribution.
A skewed distribution, positively skewed,
in the case of stock returns
means that there are more negative outcomes
and fewer positive outcomes,
but the extreme positive outcomes
are much greater in magnitude than the negative outcomes.
Another way to think about the positive skew
is a distribution with a long right tail.
As it turns out the positive skew
in stock returns is substantial.
In the 2019 study,
"Do Global Stocks Outperform U.S. Treasury Bills?"
the authors looked at 61,100 global common stocks
during the period at 1990 through 2018
and found that the wealth created
in excess of treasury bills
by the stock market over that period
was driven by 1.3% of the stocks in the sample.
The majority of the firms in the sample, 61% of them,
destroyed wealth over the second well period.
This should be staggering to hear.
Investing in most companies resulted
in negative longterm wealth creation.
And even within the sample
of companies that generated positive wealth,
it was only 1.3% of them that were responsible
for the market's overall positive wealth creation.
Even in a portfolio of stocks that is diversified enough
to reduce company specific risk,
the strong positive skew
in the distribution of stock returns
makes any reduction in diversification,
relative to the total market a meaningful risk.
The simple the solution to mitigating the risks
of total loss, uncompensated risk
and the positive skew in stock returns is diversification.
Which can be achieved cheaply
and effectively with a total stock market index fund.
We have seen that volatility is less of a risk
as we move out into longer time horizons,
as long as you can handle the emotional aspect
of ups and downs.
For the more risk averse investor,
or the investor with a shorter time horizon,
adding in some bonds to a portfolio might make sense.
This takes us to the last
and arguably the most important risk.
Inflation.
Investing is done primarily to facilitate consumption
in the future.
To do this successfully,
the investor needs to generate positive real returns.
That's after inflation.
For a long-term investor, one of the biggest risks is
that a safe feeling portfolio,
that is a portfolio of heavily weighted toward bonds,
may be exposed to substantial inflation risk.
In other words, after inflation,
bonds may not provide sufficient returns
to meet your financial goals.
From 1900 through 2018,
global bonds delivered real geometric returns of 1.9%,
while global stocks delivered real geometric returns of 5%.
A 3% annualized difference over 119 years is substantial.
The lower real returns of bonds
call into question their true safety over the very longterm.
To the extent
that the higher volatility of stocks is manageable
from a psychological perspective,
there is a strong argument
that bonds are riskier than stocks for a long-term investor.
There is risk everywhere,
and it takes many forms,
as investors hoping to meet our future consumption needs.
We are faced with the risk of total loss,
the uncompensated risk of individual companies,
sectors and countries,
and the substantial positive skew in stock returns.
All of these risks can be addressed easily
with a globally diversified portfolio
of low cost index funds.
Volatility is a risk for a short term investor
or an emotional investor,
but over the very long-term,
volatility poses less of a risk to future consumption.
Volatility reduction can be achieved
by adding bonds to a portfolio,
but their lower real returns call into question their safety
in terms of future consumption as a long-term holding.
Thanks for watching,
My name is Ben Felix of PWL Capital
and this is Common Sense Investing.
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