Why Should I Care About Investment Risk If I’m Young?
Investing Reader Question
Emily, from Evolving Personal Finance asks, “Why should I care about risk at all for investments that I won’t use for 40+ years? Shouldn’t I be swinging for the fences to get the highest possible return? For example, having a diversified stock fund but nothing in bonds or other investment classes.”
Last December I put out a shout out on one of my favorite personal finance forums, Yakezie, for Investment questions from the community. I was bowled over by the windfall of great questions. Many of the previous answers to investment questions, revolved around risk tolerance and investing in stocks versus bonds. Learn how an all stock portfolio’s returns really compare with a stock and bond allocation.
Should I Have An All Stock Portfolio?
Emily, author of the Evolving Personal Finance blog understands that historically stocks have returned more than bonds. Look at this graph of investment returns for the previous 85 years.
Taking this graph in isolation, one would think it’s a “no brainer” to invest in an all stock portfolio, if you have many years until you’ll need the invested assets. Who can argue with 9.55 percent annual returns? But this graph is deceptive.
Hidden within these 85 years are years when stocks returned negative 40 percent and even more. Those stock market drops quantify the true investment risk in an all stock portfolio.
Imagine you’re in your late 20′s or early 30′s. You’ve been investing for a few years and built up an investment portfolio of ten or twenty thousand dollars. Then, one year, your entire investment portfolio loses 40 percent. In real terms, you start with $20,000 and at the end of the year end up with $12,000.
How would you feel? Have you ever experienced that type of loss?
For another real world example, look at the recent performance of stocks, bonds, and bills.
Stock, Bond, and Treasury Bill Returns: 2002-2011
From 2002 to 2011, stocks returned 2.88 percent.
That’s not a typo, for 9 years at the beginning of this century, stock market returns averaged below 3 percent. That’s a far cry from their historical 9 percent returns.
During that same period, both cash and bonds outperformed the return of the overall stock market.
Nine years is a long time to be patient.
Many investors were frightened and panicked as they saw the dismal growth in their stock investments.
And those panicked investors did the wrong thing, they sold their stocks. Fear causes many investors to sell at the worst time.
There are reams of data that all but a few extremely disciplined investors have a difficult time staying the course in the throws of a bear market. That is why so few investor’s returns actually mirror index returns.
Mark Hulbert’s Take On Portfolio Risk and Diversification
Let’s assume you have nerves of steel, are in your 20′s or 30′s, have an all stock portfolio, and won’t bail out of the market after a large decline. How much better will your 100 percent stock portfolio perform than a 60 percent stock: 40 percent bond portfolio?
According to a recent Wall Street Journal article by Mark Hulbert, “Allocating Your Assets: How Much Stock Is Too Much?”,
“between 1926 and 1980, an all stock portfolio gained an average of 1.7 percentage points more a year than a 60/40 portfolio. Since then, the annual premium has been 0.8 percent.”
More evidence for a balanced portfolio comes from Robert Brinker, editor of Bob Brinker’s Marketimer advisory service (as discussed in Hulbert’s WSJ article), who cited a 1997 study which looked at returns of all stock versus a balanced portfolio between 1980 and 1997. This study found their returns to be almost identical.
Don’t Be Swayed by Recency
Recency, a behavioral finance bias describes a common tendency to consider recent events and assume the recent events will continue into the future. The recency effect plays out when recent stock market gains have been stellar and investors assume they will continue in the same way in the future.
An example of this recency bias was in effect at the end of the 1990′s during the technology stock boom. During the late 1990′s it was common to hear pundits proclaiming that the markets are in a new era with higher stock market valuations. These proclamations encouraged more investors to pile into stocks at their peak, only to watch the value of their portfolios tumble downward at the start of the new millennium.
The media reports that more and more investors today are moving their money into stocks after waiting on the sidelines for years due to their fears from the stock market declines in 2010 and 2011. At the start of 2012, the SPDR S & P 500 (SPY) ETF (a proxy for the U.S. stock market) sold in the low $120′s. In June, 2014 the SPY tops out at approximately $195. That’s a 62.5 percent return in about 2 1/2 years, without factoring in reinvested dividends.
The investors who sat on the sidelines during the last three to four years and get back into the markets now missed the annualized double digit returns over the past several years.
How likely is it that the next few years will yield double digit stock market returns?
If the 85 year average return of the stock market is about 9 percent and the recent four years garnered double digit returns, the “reversion to the mean” concept suggests returns going forward will likely be less than 9 percent.
Think about it, do you think that during the next few years the stock market will continue yielding returns above 10 percent?
Why Should I Care About Investing Risk If I’m Young?
Regardless of your age, a balanced and diversified index fund portfolio, is better for your mental health. Not only will a diversified portfolio of stock and bond mutual funds be less volatile over time, you won’t sacrifice much in terms of overall long term returns. That said, the future is unknown, and using history to inform the future, is an imperfect approach.
Unless you know what the future holds, owning a diversified portfolio of stock and bond index mutual funds will most likely give you a decent long term return with a reasonable amount of volatility.
A good benchmark for investing in stocks versus bonds is to subtract your age from 100 and invest the resultant percent in stock investments. If you’re 30 years old; 100 minus 30 equals 70. With this strategy your portfolio is 70 percent invested in stock investments and 30 percent in bond investments.
How old are you (feel free to ballpark it) and what’s your allocation between stock and bond investments?