A Beginner’s Guide To Understanding Stock Market Risk and Expected Returns
As the stock market gyrates and your 401K balance swing to and fro, we’re all re-learning that our investments can go down as well as up and it’s unsettling. Let’s talk about the trade-off between investment risk and returns.
Stock Market Risk and Return are Closely Related
Since 1926, the average annual total returns for stocks, bonds, and cash have been:
Risk is an abstract concept
I’ll make it more concrete by presenting three different perspectives.
First, let’s look at the range of stock returns for different time periods:
- The worst year for stocks was a loss of 43% and the best year was a gain of 54%.
- Over any 20-year horizon the range is much more narrow — the worst result was an average gain of 1% per year and the best was 16%.
Bonds are less turbulent:
- The worst year for bonds was a loss of 8% and the best year was a gain of 43%.
- Over any 20-year horizon, the range was 1% to 12%.
A second way to understand volatility is to see how often the returns are negative:
- Stocks have lost money 1 out of every 4 years.
- Bonds have lost money 1 out of every 5 years.
And for you math nerds, a third way to understand volatility is to look at the standard deviation of returns.
- With a one-year horizon, stocks returns have a standard deviation of 20%.
- With a 20-year horizon, stock returns have a standard deviation of just 3%.
Again, bonds are less turbulent as their standard deviations for these two periods are 8% and 3%.
Roughly speaking, you can think of the standard deviation as the range (up and down from the average) within which the returns should fall about two-thirds of the time. In other words, if the average returns are 10%, then the returns should fall between -10% and 30% in two out of every three years.
In all three ways of thinking about volatility, you can see that with longer time horizons, volatility is considerably dampened. This point is crucial to recognize.
Why doesn’t everyone invest more in stocks?
If stocks have higher returns and minimal volatility over long time horizons why don’t we all invest more in the stock market? This “equity premium” has puzzled economists for a long time especially given that the difference between 6% and 10% returns are large. For example, averaging 10% returns instead of 6% will give you double the money after 20 years.
Part of the answer is that we humans are risk-averse and want to sleep well every night, rather than just averaging a good night’s sleep over 20 years. Also, not all investors have long-term horizons. But it does remain a mystery why investors don’t opt for a greater concentration of stocks in their long-term investment portfolios.
If you can tolerate the short-term turbulence of the stock market, your older self will almost certainly be financially better off 20 years from now.
As you struggle with how to manage with the volatility of investment returns, keep in mind three points:
1. Risk is linked to expected returns.
Higher expected returns can only be achieved by incurring more risk. Don’t fight this as it is as true and universal as the law of gravity. Keep in mind that if you take more risks, you aren’t necessarily entitled to higher returns. Foolish risks are still foolish.
2. Your time horizon changes risk.
What seems intolerably risky in the short term can feel safer over a longer time horizon. I looked at stock price returns beginning with the 1920s and counted the number of time periods in which the stock market had a negative return:
If your time horizon was only one month, you would have experienced a loss 40% of the time. However, there has not been any 20-year period at the end of which stock market returns have been negative.
For those of you with memories of the more recent crash in 2008, the stock market was up for 9 straight years since then. It broke the streak in 2018. It took about six years for the S&P 500 to exceed the high it had previously reached in 2007.
3. Diversification reduces risk.
Most of us understand not to put all our eggs in one basket. You want to combine assets that have dissimilar patterns of returns — each should be a good investment on its own but ideally, their up and down trends are different from each other.
A simple example is a sunglasses shop at the beach. If you add ice-cold lemonade to your offerings you won’t get much diversification to protect your revenue on cold and rainy days but if, instead, you branch out with umbrellas and hoodies, you could do a brisk business in any weather.
This is why investing in different assets such as international stocks, junk bonds, small companies, and commercial real estate makes sense. Each asset class may be risky by itself, but combining them dampens the overall risk of the portfolio without diminishing the expected returns.
So, what are the practical implications of these three observations?
1. If it seems too good to be true, it is.
Stay away from hot stock tips, your brother-in-law’s new restaurant concept, racehorses, and bitcoin. These are the foolish risks that are not compensated with higher expected returns.
2. Don’t buy individual stocks and bonds.
You’re incurring unnecessary risk by being undiversified. Instead, focus on the appropriate asset allocation — i.e., the mix of stocks, bonds, international securities, etc. — that makes sense for your risk tolerance and time horizon. Once you decide what asset allocation is right for you, invest in low-cost mutual funds for each asset class.
3. Don’t try to time the market.
It’s a fool’s errand that will end in misery and regret. And, you need to be right twice — once when you decide to get out and then again when you decide to get back in. Good luck with that. To quote Warren Buffet, “The only value of stock forecasters is to make fortune tellers look good.”
4. Take more risk when you’re younger.
This is sensible for two reasons. First, you have more years of earning an income that can act as a “ballast” against the choppier returns of your investments. Second, you have the luxury of a long time horizon.
5. Take more risk when you have a higher income or more savings.
This is intuitive for reasons similar to #4. You have more of a cushion to absorb the losses when the inevitable down periods come.
6. Minimize investment expenses.
These are the fees you pay to own mutual funds, trade stocks, and engage an advisor. They are a dead weight anchor you’re dragging around, so the more expenses you incur, the less you keep for yourself. Over long periods of time, these small fees substantially reduce your wealth accumulation.
7. Lastly, if you’re stressed, don’t view your account balance.
If you’ve followed my advice on #s 1 to 6, there’s no need to check your 401K. Let it go and focus on something in your life you can control.
You can’t beat the market but don’t let it beat you up either. Have a long-term horizon, take appropriate risks, be well-diversified, and minimize your investment fees. At that point, step away and focus on your life.