Investment Risk and the Growth of Wealth: The Importance of Course Corrections
Published on - June 10th, 2009 (by J.D. Roth) 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.
So what?
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.
This article is about Investing, Planning, Retirement
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This post made me think again about my own retirement investments. I started my 401(k) in 2001, invested almost entirely in stocks as I was supposed to do as a young investor (late 20s at the time). Because I invested at a very high point in the market, the money I invested for the first 7 years of my career has been obliterated, probably worth about half of its value. That money will like never regain enough value to equal the modest gains had I put it into more conservative funds. There’s nothing to do now but try to save even more, though it’s frustrating to think of almost a decade of my economic life being wasted.
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@John Buerger: The ultimate distinction – Wealth Building results from good financial planning – not just investment planning. That is not a reality that financial salespeople in the investment houses want their clients to hear.
Totally agree with John. A well thought out financial plan has to be in place first prior to any investments being made. Each year the plan must be reviewed for course corrections. I have been doing this long enough to realize client’s change their minds – Life Happens. Parents live longer than expected and need assistance, little junior takes six years to complete college instead of four, or heaven forbid the client has huge medical problems ten years from the initial retirement goal (yet has great disability/medical insurance due to planning). Investment returns have nothing to do with any of these planning dilemmas.
Carl- great job and keep this thought process moving. Education remains a high priority for the investing public, especially to counter the message from the Wall Street houses. More investors need financial plans period. Fees paid for a solid financial plan are a great investment.
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This is an interesting discussion. I appreciate Carl bringing this discussion up and being willing to leave it open ended for discussion. This topic is important because contrary to what one of the above comments says, this is not all that common, “common sense.”
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@aconsciencelife #38.
Your use of coin flips is a good analogy, but only as long as you are sure the coin is “fair”. i.e., That it is just as likely to come up heads as tails. Problem with the financial markets is that they are not “fair”. Politicians drastically affect market outcomes – even changing rules after the game ends (ask a Chrysler bond holder). In addition to politicians,good and bad actors within companies and even the market-makers themselves also affect whether the market coin is “fair”.
If only we could assume a normal distribution curve… but alas – there are unreliable people in the equation and mathematical models often fail as a result of this (ask LTCM).
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@Craig
I read your post with much interest as it is almost identical in the emotion and words used by two 30 somethings that recently came to me for advice. In general I advise those that are just starting out with their saving/investing to invest very conservatively until they have built up a decent amount of money for this very reason. The simple truth that I have found is that for many people stock investing [whether in index funds or other strategies] is too emotionally taxing until they have a financial base built up. It is a lot easier to withstand drawdowns if you have significant reserves. That is why I think Carl’s idea about risk deserves much credit. Risk is really not a mathematical concept, but an emotional concept.
I will also add that investing as an activity is something that people get better at as they gain experience and knowledge. No doubt the last 10 years has brought many investors to their knees [the last year especially], the smart ones will use this to learn and become better.
All this is why I don’t believe passive investing [or as its called in another thread "the lazy man's way] is particularly appealing. Certainly, in a bull market it has its appeal, but the bear markets is where investors are made!
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Carl and I had a discussion of these concepts last week by phone. I am impressed whenever I see an advisor that is willing to rethink the indoctrination of “buy-and-hope” models that have clouded our understanding of risk. The five summary points are excellent and are not disputable.
Great post
Jeff
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Like Monevator, I was curious about how this concept of risk would fare in a more realistic scenario, where you invest over the course of 30 years rather than in a lump sum.
It turns out that unlike Carl’s graph above, the dollar amounts converge over time (to about 8.2%).
I used 1929-1958 (+8.5%) for my worst years and 1974-2003 (+12.3%) for my best years since I’m not sure which periods Carl used and I had those numbers available. For every dollar invested evenly over the worst period, you’d have $10.54 (+8.1%). For every dollar invested evenly over the best, you’d have $11.16 (+8.3%). Even by Carl’s definition of risk, that’s pretty safe.
For comparison, putting your money into CDs would return about $4.15 over 30 years.
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@Will,
Your analysis is flawed. You’ve looked at two periods defined by their average percentage return, but this ignores the importance of the sequence of returns (when the above average returns occurred relative to the below average returns). There were actually periods with lower average returns then your best period that would have resulted in a higher ending balance, and there were periods with higher average returns then your worst period that would have resulted in a lower ending balance.
What you saw as a convergence of ending dollar amounts was a result of the sequence of returns, not the averages. In reality, the same pattern of cash flow can vary across different market periods by hundreds of thousands of dollars, even millions, over a lifetime.
A good period of returns for a saver making regular contributions would be characterized by a heavier distribution of below average returns at the beginning with the higher than average returns at the end (when there is more money in the portfolio). This same period would be bad for someone in retirement, regularly making withdrawals, even though the market average for the period is the same. The same market average for another period could have had the higher returns at the beginning and lower returns at the end. In which case it would be good for the spender and bad for the saver.
If you really want to see the long-term risk, list out a long sequence of returns on a spreadsheet and simulate regular contributions. Then try reversing the sequence, and then randomize it a few times. Or test multiple rolling periods using the same regular contributions. The risk Carl refers to is real. It’s well documented by academics and throughout the financial planning profession.
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@Dylan: the analysis wasn’t flawed, just limited to the examples Carl gave. To extend the metaphor of a plane flying off course, investing money over time is like sending off 30 planes. Even if all of them will go way off-course in 30 years, at any given time some of them are pretty close to where you want them to be.
But perhaps that’s stretching the metaphor a little, so let’s go back to the real data (no need for random numbers). For an investor-over-time, the worst 30-year period began in 1952 and had an annualized return of 5.14%. The best period started in 1970 with an annualized return of 10.42%. For every dollar invested, that turns into $4.50 and $19.56 respectively. Although quite a spread, that’s a far cry from the $9.51-$62.53 difference that Carl talks about. As an aside, the average was 7.5% annual growth for a final dollar amount of $8.80 compared with Carl’s 11.28% and $24.71.
Based on that, I’d say that investing over time reduces risk in Carl’s sense (that is, reducing spread) compared to investing as a lump sum. On the other hand, it reduces total returns (presumably since most of it hasn’t compounded for 30 years).
Since most people are going to invest over time, I think it’s more reasonable to look at these numbers rather than assume that people are investing as a lump sum.
Which isn’t to say that I disagree with Carl’s 5 conclusions. It’s a great idea to sit down every once in a while and make sure that your financial goals are on track.
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@Will,
Perhaps I should have phrased it as your conclusion that “the dollar amounts converge over time” based on your analysis is flawed. This is not a lump sum vs. periodic contributions issue. In either case, risk increases with the passage of time. Whether you invest in a lump sum or make periodic contributions, the spread of ending dollar amounts will increase, not converge, over time.
Have a look at 40 and 50 year periods, you can use your same numbers and you will see what I’m talking about (you may need to choose different periods or stop at 38 years). It does not matter that that the numbers are different than those in Carl’s $1 best/worst example, that’s just an example. More time equates to greater uncertainty, not the common misperception that that risk goes down over time. I think that is the point of his post.
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@Dylan: But it is a lump sum vs. periodic issue. When you invest periodically, you’re basically averaging together many 30- (or 40- or 50-) year periods, which keeps the end result closer together than you’d see with a lump sum investment.
The best and worst 40-year periods for periodic investment (1935 and 1960) leave you with $10.76 or $32.46. The same numbers for 50-year periods are 1959 and 1950 with $20.24 and $82.62.
This means that the best value over 30 years is 4.35 times that of the worst. Over 40 years, it’s 3.02. Over 50 years, it’s 4.08.
On the other hand, investing a lump sum over those same periods (in their own worst/best years), you’ll get a factor of 6.58, 3.85, and 15.2 (!).
As you can see, investing over time reduces the difference between the worst and best cases, sometimes significantly.
In any case, I think the term “risk” is misapplied here, at least in the general case. As Carl mentions, we don’t care about percentages as much as we care about dollar amounts. But we also really don’t care about dollar amounts except insofar as they meet our goals. If my goal is to increase my retirement fund by 1% a year, then my risk over 30 years is essentially zero, even though the spread between the best and worst possible cases might be very large. That indicates to me that risk and value spread are two distinct concepts.
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@Will,
No one is trying to make the argument that lump sum investing is safer. You are missing the point being made, which is that the commonly held notion that stock investing risks reduce as time horizon increases is problematic because it relies on the wrong measure of risk.
Most people do really care about dollar amounts because they’re needed meet our goals. If we knew that we could hit a dollar target decades out in the future with stock investments, then that would be safer because we could simply aim for a target return, calculate a savings rate, and go. But we can’t, and further we have to go, the more off course we could wind up if we try.
Just because you got some growth does not mean you’ll be able to fund your goals and protect against inflation and longevity. Half-a-million won’t cut it if you need a million. Conversely, if you save ’til it hurts in order to aim for $1 million and markets leave you with $2 million. Your painful savings could have been reduced. These are risks.
There is a very real risk of running out of money in the future or making unnecessary sacrifices along the way. This is the risk that increases with time when you invest in the stock market. It’s a manageable risk if you know to look for it, and as Carl suggests, make necessary course corrections along the way.
If you want to run your own numbers to see this with periodic contributions, you must look at more than just two samples. The periods that lead to the widest ranges after 30 years may be different from the periods that lead to the widest range after 40 years or 50 years. I’m not offering this to challenge any notions about lump sum vs periodic saving. I’m trying to illustrate the point about measuring “risk” in periodic saving terms to help you see that the the same application of risk Carl refers to is still present.
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Carl,
Spot on AGAIN! I really like the analogy of driving to Florida and ending up in Maine. (I think I’ll have to use it myself). I’m sure there is no single source of blame here, but I wonder if advisors have such a difficult time moving the focus away from investments, and towards the other “levers” is due to financial media. 24/7 there are multiple stations dedicated to focusing on investments over what really matters. I once showed a client that even if his account rose by 50% in the next 12 months, he was still in great danger of running out of money in retirement (and that cutting spending by 15% a month could work)…guess which one he’s hoping will happen!
Russell
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