Earlier this week, I ran across an interesting tool over on the Vanguard website. It’s embedded in an article called “The Truth About Risk” and it lets you tweak a model portfolio with sliders for stock, bonds, and cash.
The upshot is that you can’t avoid risk. You can attempt to minimize your exposure to it, but there will always be some level of risk associated with your investing activities.
With stocks, you’re facing the possibility of whipsaw performance with wonderfully high highs but dreadfully low lows. With bonds, the highs aren’t as high and the lows aren’t as low, but you’re still facing potentially large fluctuations. And with cash, even though you’ll be protected in a nominal sense, you risk losing out to inflation.
In inflation-adjusted terms…
An all-stock portfolio would have returned an average of 6.71% from 1926-2011 with gains in 56 out of 86 years. The best year would have been +53.41% and the worst year would have been -37.29%.
In contrast, an all-bond portfolio would have posted an average return of 2.49% over the same period with gains in 58 of 86 years. The best year would have been +27.73% and the worst year would have been -16.15%.
And finally, good old cash. An all-cash portfolio would have posted an average return of 0.63% with gains in 54 of 86 years. The best year would have been +12.52% and the worst year would have been -15.05% (gotta love that high inflation in the 70s).
The antidote? A well-diversified portfolio and time. As you can see from the graph below, the range of returns across rolling time periods shrinks dramatically as the period length increases.
In fact, once you get out to a 10 year timeframe, it’s rather unlikely that you’ll face a loss. Possible? Yes. But not likely. And if you do it won’t be very large.
The above post shows not only the importance of diversification, but it also shows me that the re balancing of one’s portfolio periodically may even provide a better opportunity to avoid losses over time. Re balancing takes the emotion out of investing and causes one to buy low and sell high.
I think the biggest challenge for people isn’t necessarily the risk by itself its how that risk is mitigated over time. I don’t know many people that are willing to look at an investment in terms of decades though they really should.
Risk is a given.
You’re absolutely right – you can’t avoid risk. No matter we do, investing or otherwise, it carries some form of risk. With many things in daily life we make decisions on a subconscious level by taking into account the reward of the activity, but with investing we need to be much more conscious.
I think this is where a lot of people run into problems when managing their money. They often don’t fully weigh the risk factors and get blinded by the potential reward. When faced with the adversity (drawdown) that often comes with such high reward opportunities they panic and exit at the worst possible time.
So doing a clear accounting of the risk factors and coming to terms with them is an important early step in the investing process. Once you’ve done that it becomes much easier to define a good plan for your goals and to follow it long term.