A Laymans Guide to Returns Uncertainty

A Layman’s Guide to Returns Uncertainty

Psychology, Tools

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.

Volatility Trap

Avoiding the Volatility Trap

Psychology

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?