The morning after an 800-point decline in the Dow, the talking heads were on TV hyping the issues of the day. Despite a myriad of seemingly smart opinions, the market continued to sell off. One self-anointed expert opined that now was the time to “de-risk” your portfolio.
Statements like this drive me nuts. Its sounds smart—but is meaningless advice for a couple of reasons.
First, there is no such thing as a “one-size-fits-all” definition of risk. As we teach in our program at Texas Lutheran University, there are at least ten different types of risk all weighing upon a portfolio simultaneously. Consider the impact upon a portfolio from risks such as taxation, inflation, interest rates, credit, currency, politics, key-man, leverage, liquidity and general market impacts. They are all very real.
Furthermore, you can’t avoid these risks. However, you can assess them and determine which can be tolerated and which cannot. If certain types of risk cannot be tolerated, then position your portfolio to lessen the impact.
For instance, a client called this week to tell us they were closing on a new house and would need $10,000 in 60 days. In this case, we emphasized liquidity and safety. We immediately put the cash in money market. It would be crazy to put it in the stock market and expose the asset to volatility.
However, only focusing on safety, stability and liquidity presents a much larger, long-term risk. Assume you invest in a 10-year US Treasury earning a slim 3.1% per year. Depending upon circumstances, you’ll have about 2.3% after paying income taxes. After subtracting inflation of about 2.7% you guarantee that long-term funds will not maintain their purchasing power. That is a dreadful position for most people and gives a very different perspective on “safe and stable.”
Given this, most investors achieve better results by having balanced and diversified portfolios. In doing so, short term liquidity and cash flow needs must be balanced against longer term growth demands.
This often brings forth a comment like, “I just know that as soon as I invest, the market will crash!”
In the book A Wealth Of Common Sense, investment manager Ben Carlson illustrated the performance of Bob–the “unluckiest investor.”
Bob made his first investment early in 1973, right before a 48% drop in the S&P 500. Bob continued to hold his stocks after the drop and saved another $46,000. He couldn’t bring himself to invest the cash until September 1987—right before a 34% drop.
“Bad-luck Bob” hung in there holding his existing stocks and only making two additional investments before retirement. As you might guess he invested right before the 2000 crash and then, again, before the 2007 crash. Ouch!
Bob spent 42 years with terrible luck timing the market. How did he do?
Amazingly, he made money. As the market climbed through the years, Bob turned his $184,000 investment ($6,000 in 1973, $46,000 in 1987, $68,000 in 2000 and $64,000 in 2007) into $1.16 million; a total profit of $980,000. This was a return of about 9% per year on a money-weighted basis. Even after factoring for inflation, Bob increased his wealth substantially by investing in stocks.
This emphasizes some key points for delivering success when investing in the stock market. Stock investors need a long time-frame to put the wind at their back. The stock market has lost as much as 39% in any single year and 60% over a two-year period. We tell our clients that a minimum holding period for stocks should be ten or more years. This helps to dampen the volatility.
Compound interest is a very powerful force. Einstein called it the eighth wonder of the world. However, it is unlikely to benefit you if you don’t remain invested.
Timing the market is a fruitless task. Even if your timing is terrible, you still have the opportunity to earn respectable returns if you invest and hang in there.
Lastly, despite the volatility that comes with the stock market, it offers the best alternative for outpacing taxes and inflation over long time frames.