March 18, 2019: The Risk Of Stock Investing

Mar 19, 2019 | Asset-Allocation, Bonds, Economy, Feature, Gold, Headline, Income, Investments, IRA, Markets, Mutual-Funds, Newsletter, Retirement

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The Risk Of Stock Investing

There are many misconceptions in stock investing. The very first one is that stocks are risky (we even classify stocks as a risky asset class). Many investors, even the experienced ones, believe that you have to have good skills to invest in stocks. On the other hand, some people believe that if Warren Buffett can beat the market and deliver outstanding returns, so can they, or at least some other professional investors like good fund managers. In this newsletter, we will try to clarify some of these issues. 

The definition of risk 

We are often confused with the notion of risk. First, virtually everyone agrees that stocks are risky. But what exactly does this mean?

A commonly accepted definition for risk is the volatility of daily returns, or daily return standard deviation. For example, since 2000, the S&P 500 index fund VFINX has an average daily standard deviation 19%, compared with 5% of total bond index fund VBMFX. 

The other more intuitive way to measure risk is the so called maximum drawdown in a period. A drawdown measures the percentage loss from a peak to its following troughs. For example, VFINX has 55% maximum drawdown — the maximum loss occurred in the period from 2008 to 2009. This means in that period, the fund had a maximum loss 55% from one peak to a following trough. Materially, if an investor’s account only had VFINX and he/she watched the account value everyday, he/she would experience the 55% loss at the lowest trough in that period, counting from a previous peak value of the account. 

However, if an investor only looks at the account at the end of a year, the experience will be different. In fact, the biggest annual loss for VFINX is -37% in year 2008. 

What about the investor looks at the account once every three years, five years, ten years, or even twenty years? How about 100 years? Or in a more practical sense, we want to understand the investor’s experience if he/she opens his (brokerage) account statement once every 3, 5, 10 or 20 years. 

The answers, similar to looking at the account daily or annually, vary greatly. 

The risk of long term stock investing

We looked at this issue from different angles before. Let’s again look at the following table that appeared in the newsletter  April 17, 2017: Risk vs. Volatility: Long Term Stock Market Returns:

  S&P Rolling 10 Yr S&P Rolling 15 Yr S&P Rolling 20 Yr 
AVERAGE 9.2% 9.2% 9.3%
STDEV 5.0% 4.1% 3.3%
MIN -4.0% -0.3% 2.1%
MAX 21.1% 19.3% 17.9%

The above table covers the S&P 500 annualized total return (i.e. dividend reinvested) from 1871 to 2016, a total of 145 years. The so called rolling 10 years returns is that we look at annualized return (of S&P 500) for each 10 year period at the end of every month. This would accurately capture the actual experience for an investor who, once purchases S&P 500 index fund (like VFINX), only opens his brokerage statement report 10 years later for the rolling 10 year returns (ditto for 15 and 20 years). 

We can see that there have been many months when the 10-year-horizon investor experienced losses. However, when extended to 15 year horizons, there would be only one month when this investor found out he has lost money for the past 15 years, though there were many months when the investor saw very low return for the past 15 years. Finally, for the 20-year-horizon investor, there was no month he experienced a loss for any trailing 20 years. However, the minimum annualized return in the trailing 20 years is 2.1%, still somewhat low if inflation is considered. 

Of course, in the entire 145 year period, S&P 500 had an annualized 9.6% return. 

Let’s summarize:

  • Risk in investing S&P 500 index fund is virtually none in a very long term. 
  • The concept of stock risk greatly depends on the time horizon you are investing in. 
  • Specifically, if you are investing in a broad base stock index fund like S&P 500, you have little chance to lose money at the end of a 20 year period. 
  • However, you have a slight chance to encounter a loss in a 15 year period. 
  • You can expect to experience a loss in many 10 year periods. 
  • You can expect to experience a large loss in a one year period. 

Discussions

The above only looked at the index investing even though they are also applicable to any active stock fund (mutual funds or ETFs). We can further make the following observations:

  • Majority of active stock mutual funds (ETFs also) have underperformed a broad market stock index fund like VFINX in a long term. This has been proved by various research results.
  • Thus, investing in active stock mutual funds adds another layer of risk of losing money in 10 year, 15 year, 20 year and even longer periods. 
  • It’s really not worth trying to get better returns by investing in an active stock fund: since it requires a long period such as 20 years to see a meaningful investment result, you run into the risk of only finding out you have invested in a bad fund (which is very likely as majority of them do) in some late years and that can be extremely harmful as you have lost so many valuable years in the life of your investments. 
  • Investing individual stocks is subject to a similar or even greater risk as investing in an active fund: most likely, majority of investors will underperform active funds, thus, much likely to suffer from bad performance in a long term. 
  • Even when one invests in a passive index fund, he/she has another potential risk to consider: when you start to invest. For example, if the starting point is at a period of high stock valuation, you have a much higher probability to get a bad returns even after 20 years. Remember, the variation of returns in a 20 year period is very high from the above table. Even if it’s unlikely to lose money in a 20 year period, it’s still more likely to obtain a low return in that period — the annualized returns of a 20 year period vary from minimum 2.1% to 17.9%. In the current extremely high valuation, the return of the next 20 year period is almost certain to be very low. This is something an investor needs to take into account. 

In conclusions, the risk of stock investing depends on both the investment horizon (number of years) as well as the starting stock valuation. If you do have an extremely long term horizon for the investment (such as perpetual period), of course, buying and holding an index fund like VFINX right now is fine. Otherwise, investors should be careful not to allocate too much in stocks right now if you are a strategic (i.e. buy and hold) investor.  

Market overview

Stocks are now firmly in an up trend. This is not only illustrated by the S&P 500 index being above its long term 200 day moving average, it’s also confirmed by the majority of individual stocks in NYSE being in an up trend, as shown by over 56  percent of NYSE stocks whose prices are above their 200 day moving averages:

However, we should be aware that among US stocks, international developed market stocks, emerging market stocks and US REITs, only US REITs have been able to break its high. Risk assets are still yet to prove they can sustain and breach their past highs. We call for staying the course and be cautious on the risk. 

For more detailed asset trend scores, please refer to 360° Market Overview. 

In terms of investments, even after the recent retreat, U.S. stock valuation is still at a historically high level and a bigger correction is still waiting to happen. It is thus not a good time to take excessive risk. However, we remain optimistic about U.S. economy in the long term and believe much better investment opportunities will arise in the future. 

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot. 

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