How Risky Are Stocks?
Risk comes from not knowing what you are doing.
— Warren Buffett
Many people would say stocks are risky. For some, the way it fluctuates - in essence volatility; is a risk as they cannot stomach the sharp falls (but somehow love the sharp rises). To others, it’s the real chance of losing hard earned money. Then there’s a whole plethora of other types of risks such as valuation risk, earnings risk and country risk. And then, another big risk facing many baby boomers now is longevity risk - the risk of outliving your savings. The number of risks seems far too many to list.
If there ever was an unwavering rule for investing, is that risk and return are inter-related and move in tandem. High risk = high return and low risk = low return. For any investment out there that promises 20%, 30% or 40%, then you must be aware that you could lose 80%, 90% or 100% of your money. If you are unsure of how to benchmark risk and return, just take the bank savings rate as the zero risk rate.
On the other end of the risk scale would be something like options or futures trading, or punting on cryptocurrency - maybe you could double, triple or quadruple your money, but there is a high chance it all goes to 0.
So back to our main question about the risk of stocks. If you hold concentrated positions - less than 100, typically all skewed to one country like Singapore, or perhaps all in an industry you like - for example technology or airlines, then the risk you are exposed to is high. For local investors, if you took a look at your CDP statement, how many stocks do you hold that have been delisted or has had their value drop to a few hundred dollars?
However, diversifying properly - holding funds that enable you to get exposed to thousands of stocks helps to take away this company specific risk. The chart below shows the probability of stocks giving you a positive return over different rolling timeframes.
There is a good chance (3 out 4) that you get a positive return if you invest for 1 year. This gets bumped up to 4 out of 5 when you hold for 5 years. And if you do it for 10 years, this is over 9 out of 10. To get a 100% chance of a positive return (a near guaranteed chance), you have to hold for 20 years or more. As such, the risk of losing money from stocks is vastly reduced the longer you hold. Bear in mind this works only with a globally diversified stock holding of thousands of stocks.
The other argument that is frequently heard is that many investors prefer bonds for their perceived safety over stocks. It is true that bonds (the higher investment grade ones) provide safety over stocks in times of crisis. However, it does not mean that it is less risky.
Risk changes over different time horizons. Whilst bond market collapses are less severe than their stock counterparts, the advantages of holding bonds over stocks decreases over the long term. For one, many bonds do not provide inflation adjusted returns so the money you get back at maturity is worth much less than when you first put it in.
Second as the chart below shows, if you have a long horizon for holding both asset classes, the probability that stocks outperform bonds becomes very high.
And last, if you check back on all the stock and bond returns in history from 1802 to present, you will find that the standard deviation (or volatility) of bond returns is higher for bonds compared to stocks when held for longer periods. When accounting for inflation, bonds and T-bills (similar to money market instruments or deposits) still have negative returns (see highlighted part in chart below) even when held for the long term, whilst stocks do not.
To sum up; the risk of stocks can be reduced substantially if properly diversified, and the probability of stocks giving you gains is as close as guaranteed as your time horizon increases in length. The reason why investors generally do not have a good experience with stocks is that they hold too few, hold the wrong ones, and keep checking the value of their portfolio far too frequently.
If you want to find out more about how your investments can be properly diversified in order to capture as much returns as possible, come and have a chat with us.
