Defining Risk

Defining Risk

April 20, 2022

As humans, we are notoriously bad at assessing risk. A prime example being the fact that most of us get in our cars everyday and accept the inherent risks of driving at 65 miles an hour in a nearly two-ton vehicle surrounded by other strangers doing the same thing…some of them coming at us! However, many of us may hesitate before boarding an airplane for fear of the risks of flying.

Though the statistics vary depending upon the source you are citing, (we won’t get into my thoughts on the popular concept that there are “lies, damn lies, and statics”!) the facts are that your odds of dying in a plane crash are far less than an automobile accident.

The reason for this out sized fear? Strong emotion skews our ability to assess the risk. It’s natural for us to focus on the negative, on the thing that creates greater fear.

For example, if I asked you how many times in the last 42 years the calendar year returns of the S&P were positive, what would you say?

Cue the Jeopardy music….

And the answer is…32. In 32 out of the last 42 years, the S&P was positive at year-end. As a percentage, that’s 76.2% of the time.

Enter the behavioral finance concept of loss aversion. This concept points to the fact that we experience more “pain” in losing $100 than we do joy in gaining the equivalent $100.

Why does this matter? Well, market return data is very helpful in hindsight. In the moment, when we perceive that we are experiencing loss, the inclination is to want to avoid that loss, to jump ship, to abandon the well thought out investment strategy and financial plan in favor of avoiding the pain of loss.

If we look to the above chart, in 1998, there was a calendar year return of about 27%. However, the red dot, which indicates the market pullback in each year, shows us that the market declined by 19% at one point that year. If on August 27th, my 18th birthday, when the market was down about 13% from its peak just a month earlier, you decided that you just could not take any more “loss”, you would have missed out on about 21% gain in the last 5 months of the year.

(Well, to be fair, you would have had to ride out another nearly 6% “loss” before things shifted and the market gained a total of 28% to close at a total gain of about 27% for the calendar year.)

The moral of the story - the market fluctuates. It’s normal. The reasons it fluctuated so much in 1998 are going to be different from the reasons it fluctuated in 2020 and different from the reasons it fluctuates in 2022 or 2023. (In case you had forgotten, the reason for the fluctuation in 1998 was in large part due to the Long-Term Capital Management Hedge fund crisis.)

I propose redefining how we think about risk. The real risk, in my opinion, is whether or not you can count on the dollars you need being there when you need them.

This is why we perceive stocks to be “riskier” than bonds. In the short term, you have a greater likelihood of being able to count on the money you’ve allocated to bonds “being there when you need it” next year. Stocks are (generally) more volatile than bonds in the short-term, meaning there is a wider range of possible outcomes – your $100,000 could grow to $147,000 or decline to $61,000 (though the likelihood is greater for growth than decline as we just learned.)

The reason I say that stocks are “generally” more volatile than bonds is that this year, that statement is not necessarily true. As I sit here on April 20th, the S&P 500 index is down about 7.5% year-to-date, while the Barclay’s Aggregate Bond Index is down almost 9%.

Setting this year aside, the following chart shows us what a possible range of returns may be (historically) for stocks, bonds, and a combination of stocks and bonds over various time periods.

At the end of the day, we are not investing for the short-term, we are investing for the long-term. When we look at the one-year data, yes, stocks can be labeled “riskier” than bonds if we need to be sure the $100,000 we put in at the beginning of the year is available to us at the end of the year. The longer the investment time horizon, the more that risk diminishes.

The longer the investment time horizon, the greater the risk of inflation, or the risk of erosion of our purchasing power. This has long been the “silent risk” that has reared it’s ugly head in the last year.

If we assume a long-term, average rate of inflation (which hovers around 3%) over a 20-year period, that means that what you could by with the original $100,000 you invested, would now take roughly $180,000 to purchase the equivalent 20 years from now.

This is why there is also risk in keeping money in savings accounts that are not keeping pace with inflation – 20 years later, you can’t buy the same things with the same $100,000. In fact, your purchasing power is almost half of what it was 20 years earlier.

If we circle back to the “will the money be there when I need it” assessment of risk, the question now becomes, “will how I’m investing preserve and increase my purchasing power as much as I need for the future?” aka “will the money be there when I need it.”

You don’t need all of your money the day you retire, you don’t need all of your money next year, you don’t need all of your money in five years. What you do need is an investment mix that preserves your purchasing power and a conservative allocation for the money you do need to live on in the next 1-2 years.

What we do need is to redefine how we think about and assess risk. To make sure the purchasing power we need is there when we need it.

To learn more, schedule a complimentary consultation with Lauren E. Hawekotte, CFP® here.