Balancing Risk & Return
Joseph called wanting a second opinion.
He and his wife, Kimberly, had been arguing over money and realized they might benefit from a third party to calmly assess their situation. The interest from a certificate of deposit from a local bank kept dropping. As such, they were open to other ideas—even if it involved putting funds to work in the stock market.
In the past, Joseph “gambled” in certain stocks—trying to trade in and out. As expected, this did not work out well and it built up resentment. As such, Kimberly was hesitant.
At Kimberly’s insistence, the couple was now looking for guidance and a more thoughtful, longer-term approach.
When we met, Joseph was surprised when I said that to be a successful long-term investor he should be willing to tolerate shorter term volatility to earn longer term returns.
Joseph was even more surprised when I said he needed to be prepared to see his stock market assets fall by 40% in any one year and by 60% over a two-year period to gain the benefit of the long-term averages. Joseph thought this was crazy.
Joseph’s response is quite typical.
Seven times in the past fifty years the US stock market has fallen by at least 30% over a twelve-month period. On a few occasions, it has fallen by 60% over a 24 month period. And yet, over long time frames, generally 10 or more years, it still delivers returns that allow wealth creation in excess of taxes and inflation.
Furthermore, we discussed that the long-term value of a business is generally determined by the earnings a company makes. Despite this, many good companies still see their stock price fall over short periods–even if they continue to earn more money during a downturn. This was certainly true during the downturns of 2008 – 2009, 2020 and 2022.
Joseph countered and said he’d be better off investing in a 10-year US Treasury bond, which is “risk-free.”
In assessing this we pointed out that a 10-year Treasury would pay interest of about 4.1% per year. Then Joseph would owe income taxes, at his marginal rate. In Joseph’s case it would reduce his return by 40% leaving him with about 2.4% after tax.
Then we asked Joseph about the impact of inflation. He was silent.
If you accept the government’s metric, then inflation is running about 2.8%, currently. This would mean Joseph’s purchasing power would actually decline over the next ten years.
Joseph started to realize that his idea of a “risk-free” investment was riskier than he thought as it guaranteed long-term erosion of his purchasing power.
Furthermore, we explained there are many types of risk present upon a portfolio every day. Focusing all your attention on just one type of “risk” can leave an investor far more exposed than they realize.
This resulted in a productive conversation with a few key points.
Depending upon the asset, you can expect different outcomes depending upon the time frame.
Many people think they know what will happen in the stock market over short periods of time. None have proven long term success at such prognostications.
Volatility is not the same thing as risk. Risk comes in many forms and cannot be avoided. Rather it must be managed. As such, smart investors structure assets to serve different purposes and time frames.
Short-term liquidity and cash flow must be balanced against longer term growth demands. Most investors achieve the best results by having balanced and diversified portfolios. Emergency funds that might be needed anytime over the next twelve months are best positioned in money market or something with similar stability.
The stock market is guaranteed to be volatile—especially over shorter periods of time. Successful stock market investors focus on where they want to be ten or more years from now. Furthermore, they don’t allow short term bumps to disrupt the long term plan. As such, patience and optimism are most valuable skills for any successful investor.
Dave Sather is a CERTIFIED FINANCIAL PLANNER and the CEO of the Sather Financial Group, a fee-only and fiduciary, investment management and strategic planning firm.
