Most people intuitively understand that time is a critical component of investing. Whether it’s the time it takes to work and save a portion of every paycheck or the miracle of compound interest that gets better and better as you go, the importance of time is a central part of any detailed investing discussion. But the human brain is sometimes ill-equipped to comprehend things that are far away, and that can lead to some mental over-simplifications that obscure the reality of future uncertainty. For example, let’s talk a bit about a question I see come up pretty often:
Do stocks get less risky the longer you invest?
One of my absolute favorite movies of all time is Raiders of the Lost Ark. There’s a famous scene where Indiana Jones is confronted by an intimidating swordsman clad in black, and the crowds part in anticipation of an epic fight. How does Indy handle such an ominous threat?
Like so many of my fellow red-blooded Americans, I love football. And it probably will come as no surprise that a numbers person like myself also has a soft spot for that special nerdy subset of football all about stats — fantasy football. The excitement of one of my favorite sports wrapped up in numbers and friendly competition with long-time friends is something that makes football season all the more fun.
If you’re one of the 41 million people who play fantasy sports every year, you know how intoxicating it can be. That’s great when dealing with a fantasy team with perhaps a few dollars and a trophy on the line, but what happens when the same methods for selecting a fantasy team are applied to your life savings? As I prepared for my own fantasy draft I was struck by how the two industries of fantasy football and personal investing cater to human psychology in nearly identical ways, and it made me appreciate the mental traps that can easily lead even highly educated investors to make poor decisions.
Unless you’ve been living in a cave the last week, you’ve probably heard a great deal of news and opinions about the vote in Britain to leave the European Union. And even if you managed to completely avoid the news cycle, perhaps you took a peek at your investments and wondered what was going on. Clearly international events are affecting the markets, the future looks quite uncertain, and many investors are in an emotional whirlwind.
Rather than add to the pile of opinion pieces pontificating on the uncontrollable, I thought I’d take a moment to focus on what we as individual investors can learn from this situation and how these lessons can be used to improve our personal portfolio choices. I have no earthly idea how markets will react to this news over time, so let’s talk about something a little more close to home — how you react to unexpected market adversity.
It’s that time of year again when students around the country are graduating. Finishing one long journey is a combination of fear, relief, and joy, and looking forward to the one to come is part of what makes it such a special moment. It’s also a great time for personal reassessment, and the expectations an eager graduate sets today may have a measurable effect on their future success.
Watching your account balances when markets are volatile is really tough. Some people like to attribute that uneasy feeling to an undesirable excess of emotion, and believe they simply need to keep a cool head and think rationally. While that’s certainly a valid point, in my experience even the most stoic investing robot has a major blind spot when it comes to investing psychology. It’s not a character flaw, but simply human nature.
Intelligent, well-educated investors will look at a variety of investing options and make a selection at least in part based on long-term empirical measures like the average return. These smart investors are naturally wired to evaluate the world around them with their five senses and act with reason and numbers. Now these are both admirable behaviors, but there’s already a logical conflict brewing under the surface in the last two sentences that gets exposed with a wildcard many aren’t truly prepared for — uncertainty.
In my experience, when an asset allocation seems on the brink of disaster right now, the problem is most often not with your portfolio but with your perception of what an average return or a standard deviation really means. Human brains are just not naturally wired for uncertainty, and sometimes very rational people struggle with it the most.
With recent stock market turmoil, there have been plenty of renewed questions from nervous investors about the concept of investing risk. Are stocks really a good idea? Is the volatility worth it? Should I get out now while I still can?
Astute stock market bears point out that there have been many rolling periods where the inflation-adjusted stock market lost money for more than a decade. Recently, a 100% stock market investor starting in 2000 experienced 13 years of negative real returns before finally breaking even. Stocks absolutely do work out well in the long run, but if you’re not prepared to wait them out for at least a decade without questioning your plan and switching course, you may be in for a tough emotional ride. And remember, if you switch portfolios all the time you generally lose money.
Cooler heads are understandably fond of quoting the long term average returns of the stock market. Since the S&P500 averaged an 8.5% inflation-adjusted return since 1900, there are many years of history to prove that if you are patient and invest for the long run, it will all work out for the best. “High risk, high return” is a common mantra, meaning that the extra volatility carries a proportionally higher reward.
The idea that returns are linearly proportional to risk often leads to well-reasoned (but shaky, as I will explain) decisions about asset allocation. Would someone trade 1% a year for significantly more dependable returns? Judging by the popularity of hedge funds with expenses in that range that seems like a reasonable assumption, and retirees looking for consistency over maximum growth might find that particularly appealing. Would they trade 2-3% a year? Maybe not. That’s a lot of money to give up over time. So people study the averages and make the best decision they can.
But what if I told you that the risk adjusted return for stocks is a lot less than you might think?