My finance professors taught me something that I have found to be questionable if not inaccurate: volatility is a proxy for risk.
The stock market in 2018 is a perfect example of why I question the principle. Investors drove the price of stocks sharply higher in January in anticipation of economic growth and income tax cuts. Since January 26th, the S&P 500 including dividends is down 4.5%. Stocks have been on a down roller coaster since then. Yet despite all of its whipping around, stocks are actually higher now than they were on New Year’s Day.
Warren Buffett wrote about risk in his 2014 letter to shareholders:
Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions.
Volatility is far from synonymous with risk. For the great majority of investors, however, who can – and should – invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities.
So what in plain English is Buffett telling us?
He teaches that investing in stocks is far less risky than investing in a money market account if you do not need cash. It is critical to focus on keeping up with inflation to maintain your purchasing power. But the big IF is: can you invest with a mindset of decades instead of days, weeks, and quarters?I imagine that most of you define risk very simply as the probability of losing money. The missing link is that many people have a hard time placing a time frame on the loss. Investments in stocks go up and down every day. In looking at the S&P 500 including dividends as of the end of June, stocks are up 31.3% since the 2016 election. So far in 2018 stocks are up 2.6%.
Yet since January 26, 2018 at the peak of the market, stocks are down 4.5%. The richest, most successful investor in the world advises you to think very long term, over multi-decades, so that declines over days and months and even are years irrelevant.A diversified portfolio rebalanced and added to year after year will be far less risky than any other strategy. This concept is very logical, but so difficult to maintain long-term. Why?
I see three things that get in people’s way. First is the media. CNBC could not build much of an audience if its message was, “Construct a balanced portfolio and ignore our talking heads.” It is in the best interest for TV, newspapers, and internet outlets to focus on quarterly earnings, forecasts, hunches, market timing, hot stock tips, etc. The second problem: paid helpers and salespeople who push you to buy expensive or complex products like annuities, hedge funds, and private placements. You feel like they are helping you, but they are really helping themselves. The third problem is your brain.
We are wired to avoid pain, and it takes a strong mindset to be a successful multi-decade investor. It is so hard to develop a plan and stick with it when the world is spinning all around you. Politicians are scary, one country or another is always on the brink of war, trade wars loom, airplanes fly into buildings in NYC, corporations implode, subways are bombed. It never stops.
Please re-read Warren Buffett’s advice above and try to change your risk mindset. You will be wealthier and happier too! Next month I will discuss risk for those in or near retirement.
This article was featured in the July 8, 2018, print version of the Knoxville News Sentinel. Tom Coulter, President of Meridian Trust, can be reached at firstname.lastname@example.org.