Rethinking Risk

The misconception that the stock market is 'risky' has become a notion that dissuades many folks from investing, due to a fear of losing money. However, without taking the time to precisely understand the risks an investor faces regarding long-term wealth accumulation, I worry that many people may be focusing on the wrong risks. Thus, in order to gauge the risk of an entire asset class we must first:

1.         Define what the risks are

2.         Determine how much weight we should place on them

I will save you the suspense and lead with what I hope you take away from this piece: When your goal is to build wealth, the risk you face is not a decline in your portfolio’s value in the short term; it never has been. The real risk we all face is much less visible and way more detrimental: outliving the portfolio.

Risk as Volatility

When the typical investor says the word “risky”, they are referring to elevated levels of volatility. Volatility refers to how quickly the price of an asset moves over a given period. When people use volatility as a proxy for risk, they are not necessarily wrong. Volatility within your portfolio can be a real risk in the short term. This is why short-term goals require investments with lower volatility, and also why low volatility investments (bonds, GICs etc.) pay you less to hold them.

Short-term declines within your long-term time horizon can be challenging to withstand. These downturns are exacerbated by the media, which pushes fear mongering headlines at you from every direction. It is natural to react with emotion and fear to falling markets. As a result, emotional decisions drive our behaviour instead of historical evidence. I have yet to have someone call me to say:  “Hey Calvin, it looks like we are experiencing a perfectly normal 10% decline in the markets which also happened in ’02, ’03, ’08, ’09, ’10, ’11, ’15, ’16, ’18, ’20 and 2022. I understand this is inevitable when holding equities given their short-term volatility, but over the long term my portfolio is going to outperform those who sell or never entered in the first place”.

The chart below is extremely informative. Take a look at the boxes in the negative territory which display the largest intra-year decline in market value over each calendar year.  What do we notice? Over short periods the market does go down. In fact, in any given year, you can expect the SandP 500 to be down over 10% at one point. Now take a look at the grey bars. These show the total calendar year return on the SandP 500. Evidently, 34 out of 43 years are positive, representing capital appreciation. The average annual increase was 11.88%.

 

What can we take away from this? Having the emotional intelligence to hold on to investments during times of uncertainty, increases the probability that we are going to end the year in a better position than where we started. In other words, trust the data.

Risk Throughout the Years

The public overestimates the long-term (5-10 years) risk of owning stocks. Need proof? If you were to pick any 1-year rolling period at random from the broad index of U.S. stocks between January 1, 1935 through December 31, 2021, the chance that the overall market increased in value was 79%. The probability of making positive returns on any 3-year rolling period was 85%. Lastly, since 1935, the probability of your investments appreciating on any 10-year rolling period was 95% (100% for Canadian stocks) Source: CIBC Asset Management. Think about all of the events throughout the last century: WW2, US housing crisis, 9/11, pandemics, liberals, conservatives, Trump, no Trump, it didn’t matter. In recessionary periods, well-managed companies are able to steal market share from over-leveraged firms and end up in a better position at the beginning of the next economic cycle.

 

 

 

 

What I hope you now see is that the risk of losing money in a well-crafted portfolio over the long term is negligible. The risk you face is losing money when it is needed. That is why professionally managed portfolio construction is crucial to ensure your asset allocation is tailored properly to meet your goals and to ensure you have enough liquidity within your portfolio to meet your cash needs when they come due.

Now that we can all agree that the risk of losing money in a diversified portfolio over a long-time horizon is negligible, we can move to the larger, much more significant risk that we all face: Over the long term, history shows us the risk of losing money in asset classes like equities is low, but the risk of losing money to inflation is significant.

 

The Real Risk: Inflation and Outliving your Portfolio

When we talk about long term wealth creation, the risk we all face is usually a silent killer. However, over the last 12 months, it has taken to the forefront of our economy. Elevated government spending, supply chain shortages and increased energy prices, among other factors, have led to the largest inflation growth of my lifetime. Some readers of this post will have memories stretching back to the 1970s and 1980s, when inflation peaked at 24.21% in 1975 and 17.97% in 1980 (Source: foresight). The increase we are all seeing today at the grocery stores and gas pumps have become not-so-subtle reminders of the damaging effects of rising prices we are all experiencing.

 

 

 

Lately, I have been hearing the argument that “as long as my income increases at the same rate as inflation, then I have broken even.” This logic couldn’t be more wrong! This argument neglects to account for all of that hard earned money you’ve been saving for years. Allow me to give an example. Fred has $2million in savings and makes $200k per year. If inflation increases 100%, and his salary moves with it, he now makes 400k. But the value of his 2 million gets cut in half! Inflation wipes out the value of your already accumulated assets. It is important to drive home the risk inflation poses to all of us: If the after-tax growth of your savings does not outperform the rate of inflation, you have lost money. That is why inflation is the silent killer. It slowly eats away at your piggy bank over time and unlike your portfolio, you don’t get a statement every month telling you how much you’ve gained/lost.

Yet there is hope! You can beat inflation, and to do so is actually rather easy. Over the last century, equity markets have grown and increased their dividends at a greater rate than inflation. Many companies use their excellent pricing power to pass on rising costs to their customers. According to Forbes, your long-term investments will need to earn at least 3.7% to keep from losing ground to inflation (accounting for tax). Luckily, broad equity markets in North America have experienced compounded annual growth rates of 7-10% over the last 50 years and bonds have provided steady returns of roughly 5%.

 

 

 

 

Final Thoughts

The risks associated with investing are dependent on you and only you. No two clients we work with have the exact same goals, time horizon, liquidity needs and investment constraints. This is why we craft portfolios tailor-made to each individual client, based on their specific needs, to mitigate the risks that they face. On behalf of everyone at the Greenwood White Group, we look forward to continuing our work with each of you to ensure that your portfolio is best suited to meet your financial goals.