New Research Shows You Are Not Viewing Risk Correctly

by Aug 14, 2020Investment Strategy, Market Insights

Every investment carries risk, but most investors view risk incorrectly. While some investors have a higher risk tolerance because they are trying to achieve high return on investment and are willing to take a loss while trying, other investors have to be a lot more careful. This is particularly the case for retirees and soon-to-be retirees because they have less time available to recover unexpected losses. And some don’t have the ability to go back to the workforce to do so. If you are in this age group, this article is for you.

Current crises have many possible outcomes

Let’s look at two current events: How quickly may we be able to recover from the financial effects of the pandemic? And what about the tense US–China relationship, which seems to be souring by the day? Are you confident that either of these crises will be resolved fast? Our economy has been feeling the effects of both crises for months, and although we have escaped a total financial meltdown so far, they could still drag down our economy. And we must not forget the aftermath—the long-term effects of the decisions being made today, which could have horrible consequences farther down the road.

Are you 100% confident things will be fine? Then, are you 100% in the equity and bond markets?

The further we look into the future, the more outcomes are possible. In terms of our relationship with China, a regional shooting war is unlikely to happen this year, but some analysts are saying the odds are very high it will happen this decade. And those are just two crises—we don’t know what other events could occur that might threaten our economy. Did we see coming a worldwide pandemic disrupting everything we took for granted?

The typical assumption when doing financial planning for retirement is that risk goes down the longer the time horizon. “Things will work out” if we invest for the long term. But is this true?

Does risk increase or decrease with time?

Robert Stambaugh, Professor of Finance at the Wharton School, and Lubos Pastor, Professor of Finance at the University of Chicago, have studied the subject, and their findings are upending traditional retirement planning. (If you’re interested in their research and the underlying statistics, you can consult their paper, Are Stocks Really Less Volatile in the Long Run?, which can be found here.)

The traditional assumption behind the notion that risk declines over time is that good periods and poor periods follow each other. This is called “regression to the mean.” Profs. Lubos and Stambaugh agree that this concept is indeed a powerful force in financial markets, but they argue that stronger forces exist that offset the “regression to the mean.” You can read the details in their study.

They have devised a formula to determine how much stock market risk grows over time when you consider both the regression to the mean and the other forces. According to this formula, moving from a 1-year horizon to a 10-year horizon increases risk by roughly 10%. If you move from a 1-year horizon to a 30-year horizon, risk jumps almost 50%.

As an example, we can look at the Japanese stock market over the past 30 years: the Nikkei 225 Index currently trades at around 50% of its value three decades ago. Lubos and Stambaugh are in essence saying that we shouldn’t feel too confident in the resilience of the US stock market over long stretches of time. The fact that it is highly unlikely it will drop 50% tomorrow doesn’t mean it won’t or can’t crash and remain 50% lower over 30 years just like the Japanese stock market.

And before you huff, “That is not possible!,” you should note that after the Great Depression, it took our stock market 25 years to reach its previous all-time high, and during the ’70s, the equity markets gained an average of 1% over the entire decade, while high inflation was raging. The real purchasing power loss for the equity market investors was incredibly high.

Deep down, we know the two professors are right. For the immediate future, we are confident; we probably won’t lose our job tomorrow, and the stock market probably won’t be cut in half by tomorrow either. When we look further into the future, however, and consider what crises could happen in the next decade or two, I bet you agree with me that we feel less confident. Risk grows over time. It’s as simple as that.

How to lower the risk to your portfolio

So, what can you do to lower your risk as a retiree or soon-to-be retiree? A good starting point would be to lower your equity allocation, especially considering that the current, frothy market doesn’t reflect the challenges our economy and we Americans are facing today—our real economy is suffering. Sooner or later, the markets should be too. The key is diversification. Not a single asset should get 100% of your pie. If you own stocks and bonds, you should add precious metals to the mix. Metals such as gold and silver are the most uncorrelated assets to the equity markets. Having assets like gold and silver that go up in value when the dollar or the markets go down may save the retirement portfolio you are holding over many years as you may not have the time and ability to wait for the equity markets to correct if a decade or more of underperformance occurs.

May you be healthy and safe during these trying times.

Joseph Sherman

Joseph Sherman

CEO, Gold Alliance