This is a guest post from Carl Richards at Behavior Gap.
I have a problem. In fact, I think we all have a problem:
We have been way too focused on returns, resulting in the utter destruction of our wealth.
The investment industry has been built using tools that might be appropriate for understanding investments, but are totally worthless for investors. In real life, real people, using real money do not care about returns. We care about our wealth, and the two are not the same. They are not the same!
Risk and investment returns
Nowhere is this paradox more evident than the core tenet that risk goes down over time. When talking about investing, everyone says that risk goes down over time. Every investment book, every investment advisor, and for sure any class you took in college, all shout this idea from the rooftops, an idea illustrated in the chart below.
It’s time to back up and understand what this chart is really telling us.
It measures the best and worst periods in terms of annualized returns from 1926 through March 2009 for the S&P 500, with the average return for the entire period in grey.
For example, while that average return for the entire period is 11.28%, you had a one year period that was positive 162% or negative 67%, a three year period that ranged from up 43% per year to down to 42% per year and so on. As you measure longer and longer periods, the best and the worst start to narrow around this long-term average of 11%.
Just to make sure we are clear before we move on:
- This is a chart of the range between best and worst annualized rates of return for different periods of time.
- It clearly shows that the range of potential outcomes (in % terms) narrows over time.
Somewhere along the line, someone locked in a back room at a university decided that the range of returns (measured in percentages) was a good proxy for risk. Somehow it is was useful to measure risk in terms of how much something goes up and down in percentage terms.
This is where things get sticky.
Risk and the growth of wealth
It might be true that “risk” goes down over time, if you define risk this way. If you are an investment, this would be a good way to measure risk. But you are not an investment — you are an investor. Real people do not care about their return. We care about our money. We don’t eat percentage pie. You can’t pay your kids’ tuition with percentages; you pay with dollars. Everyone I have ever met thinks of risk as the possibility that they will run out of money.
So the question is not about the accuracy of this chart, but about the conclusion that we draw from it. When you are a real person, measuring risk in terms of returns is like trying to measure temperature with a ruler. Fine tool — wrong application!
Investors measure risk in terms of dollars; investments measure risk in terms of percentages.
When we measure risk in terms of wealth, risk goes way up over time!
The chart looks like this:
This chart shows what happens to a dollar if we invested during those best and worst time periods from chart one. Depending on the sheer luck of timing, $1 could have ended up growing to $62.52 — or just $9.51 thirty years later. That is a huge range of potential outcomes. If you add in withdrawals, things get even more “risky”.
This should make sense. It’s basic math, compounding over time. When you leave on a trip from Los Angeles to Miami, if you are two inches off course, you most likely would not even notice when you are over Nevada, but without any course correction you will end up in Maine! Maine is not a bad place — unless you planned to be in Florida.
The issue is that most of us are on auto-pilot, thinking that if we just “set the course and forget it” that our risk will go down over time.
That is simply not that case.
I’m still working through all the implications of this, but they at least include the following:
- The timing of major financial decisions has huge impact on our success. If you happened to retire with a lump sum at the beginning of one of the best 30-year periods, your experience would be dramatically better than if you retired just before one of the worst. The problem is that we really don’t know which one we are in until after the fact.
- Average is not normal. If you set a course based on some version of a long-term average return, then you are likely to end up somewhere else. Most of the time, the surprise destination appears to be good, but sometimes it’s bad. In fact, it’s bad often enough to make me question some of my long-held beliefs.
- Making course corrections is at least as important as setting the course!
- Rates of return are only one factor in meeting your long-term goals. There are other levers to pull when we need to adjust, other levers that we have much more control over, including retirement date, savings goals, withdrawals, etc.
- We really can’t rely on the idea that if you buy and hold, your risk goes down. While that may still be the best approach to investing, in terms of meeting your financial goals, there are a lot of other things that you need to think about as you go forward.
The point of this article is really just to raise awareness. I have been thinking about this for a long time. I have been in the financial-planning industry for over 10 years. I really can’t think of one concept that is more important to understand right now. Here’s a video that summarizes my thoughts on this subject:
I want to leave this open-ended. This is the beginning of a discussion, not the end. However, it’s important to understand that the process of planning for your future remains the same:
- Determine where you are today.
- Define the destination.
- Chart a course to get there.
But now that you know your risk of not getting there is actually growing over time, make sure you take the time to do regular course corrections. Are you on course to meet your goals? Have you made corrections in the past — or do you expect to do so in the future? How do you feel about the relationship between wealth and risk?
You can read more from Carl at his excellent blog, Behavior Gap.