Quantify the risk-return trade-offs of the investment
By Massi De Santis
In most cases, we can rely on prices to assess the cost of our decisions. If what we’re getting is more than we’re willing to pay for it, the purchase makes sense. Prices make it easier to assess trade-offs. When it comes to investing, however, the costs of our decisions are less apparent. For example, the S&P 500 has averaged over 10% per annum since 1970. Surely there must be a cost to pay to get that. What is the high yield for? The standard answer is that you have to go through the ups and downs of the stock market to get potentially high returns. But what does that mean?
Not fully understanding the risk of stocks is one of the main reasons investment plans go wrong. Thinking that all you have to do is sit back and wait can lead investors to overestimate their tolerance or capacity for risk. It can also lead others to think that by doing a little more you can achieve highs without the lows. Misunderstanding can also lead to opposite reactions, such as staying out of risky investments for fear of losses when it may be wise to take the risk. How can we better understand the risk of stocks and other investments, and how can we use this information to help us select an appropriate level of risk for our goals and needs?
Short-term losses are part of the race (S&P 500, quarterly data)
The 10% annualized return on stocks means that a dollar invested in 1970 rose to $ 182 fifty years later, as illustrated in the graph above. However, the journey was far from smooth and the short-term losses were regular. Blue areas show when the index was below its previous peak, and by how much.
The previous high is relevant here due to our tendency to anchor our expectations to it and our sensitivity to loss, a behavior known as loss aversion. Knowing that your portfolio went from $ 900,000 to $ 950,000 this quarter, it is good if your previous peak was $ 900,000, but not so good if the previous two quarters the value was $ 1 million.
The chart shows that in more than half of the quarters of the period (51%), the S&P 500 traded below its previous high. The percentage by which the index is lower than its previous peak is higher than 10%, on average, but it can be higher (more than 40%) and for long periods. The blue area shows that one of the costs of investing in stocks is many quarters of potential disappointment.
Loss aversion and risk
The returns can vary so much from year to year that even though the average is 10%, the annual returns are almost certainly different from that. Over a 12-month period, the returns of the S&P 500 can go as high as 61% and down to minus 43% (using monthly data). Getting a 61% increase in your nest egg can be nice, but what would you think of seeing a $ 1 million portfolio drop to $ 570,000 over a 12 month period? Could you get through this without losing sleep? Besides long periods below previous highs, large potential losses are another cost of investing in stocks for the potential for higher returns.
The figure below compares the returns of some stock indexes with the returns of one-month treasury bills.
The trade-off between risk and returns (1970-2020)
While the stock markets have tended to reward investors with relatively high returns, the lower part of the figure shows that losses over a year can be substantial. In contrast, safe government bonds like Treasuries have not experienced any negative one-year yields in the period since 1970. Yields, however, are much lower than those of stocks. It is the relationship between risk and return. Notice at the other end of the spectrum how small cap stocks have had higher returns than large stocks, but also higher losses year over year.
In a typical portfolio, we can achieve intermediate levels of risk and return by mixing different stocks and bonds, as shown in the table below.
Risks and returns of the various equity / bond allocations (1970-2020)
Focusing on the 50/50 portfolio, you can see that the one-year yield range is between minus 25% and 61%, which is about half of the range of the S&P 500 alone (-43% to + 61% ). As we increase the percentage allocated to stocks, the range widens. But over time, even a little over three years, the range narrows considerably.
Match the range of outcomes to your goals and preferences
The range of outcomes can help us quantify potential losses and the relationship between risk and returns. However, these values only make sense if we can relate them to our goals and risk preferences.
Consider the preferences first. If you are affected by short-term movements, check your account balance often, tend to ruminate on past decisions, and are likely to change your investments after substantial losses, you may overreact to short-term losses. Be aware of the potential losses from your investments and decide if that may be too much for you. A risk tolerance questionnaire can help you determine your risk preferences. Ask us for our free risk assessment.
Next, consider your goals and your financial ability to take risks. For example, suppose you are planning a large purchase in the medium term. It could be a college goal or a big home renovation. How much can you afford to lose while catching up with additional savings over your investment horizon? Could you make up for a 20% loss on the remaining time with additional savings? Or would you have the option to postpone your goal? The answers to these questions depend on your goals, your priorities, and your ability to save, which together form a concept we call risk capacity.
Understanding the relationship between risk and return helps you clarify the cost-benefit trade-off you make to achieve your goals, and it helps you create a structure for making investment decisions and managing your portfolio, your plan. investment. You can start by creating your own plan define your goals and priorities and assess your risk capacity. Then use the tables above to start establishing an asset allocation for your goals.
Read the first article in this series here.
About the author: Massi De Santis
Massi De Santis is an Austin, TX paid financial planner and founder of DESMO Wealth Advisors, LLC. DESMO Wealth Advisors, LLC provides an objective financial planning and investment management to help clients organize, develop and protect their resources throughout their lives. As an independent, fiduciary and fee-based financial advisor, Massi De Santis never receives commission of any kind and has a legal obligation to provide impartial and trustworthy financial advice.
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Email Jeffrey Levine, CPA / PFS, Director of Planning at Buckingham Wealth Partners, at: [email protected]
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