It seems fair to say that the biggest single topic in the financial media related to investment management for the doit yourself investor is RISK. The Risk of outliving your money (which almost never happens); the Risk of stocks and the safety of bonds (which is much more complex than depicted); the risk of the 4% rule (which no sane person ever fully commits to), etc. To understand this reporting, let’s lay out a few facts up front.
- If it bleeds it leads!
- The objective of the media company is to generate clicks!
- Scared people click the most!
Since we react to bad news much more reliably and quickly than to good news, the press has to always lead with that. When unemployment falls we hear, “Labor shortage threatens economy…” When it rises we read, “Collapsing economy will destroy retirement accounts…” When the Fed raises interest rates we see “Fed intent on destroying housing markets…” When they cut rates we see “Fed desperate to avoid depression…” We can go on, but I suspect you get the point. Often you find that the story is much less sensational than the headline, but the headline remains front and center. Many don’t recognize that the writer does not create the headline. That is an editorial function for marketing purposes. The bottom line is Scary things sell and RISK is scary.
What is Risk?
What is this demon king of which you speak? Exactly what is risk? Now things get complicated. Mathematically speaking, most investment professions simply mean “Variance” (or equivalently, Standadrd Deviation) when they use the word RISK. This stems from the fact that that this is the measurable term based on real data, and it is easy to show that variance reduces accumulated returns over time. Consequently, this is a coherent, universally acceptable usage.
Consider this. Start with $100. Assume that the return over 2 periods is 0% in each period. We start with $100 and end with $100 – cool. Now start with $100, see a 5% gain (or loss) followed by a 5% loss (or gain). Intuition suggests that we end up where we started because 1 * 1.05 / 1.05 = 1. But that’s not quite the way it works. In this case we end up with $100 * (1+ 0.05) * (1 – 0.95) = $99.75, or $100 * 0.95 * 1.05 = $99.75. If we see a 10% gain (loss) followed by a 10% loss (or gain) we end up with $100 * 1.1 * 0.9 = $99.00. All that has changed in these three settings is variance, and it is clear that as we move from a 0% range to a 10% range to a 20% range the ending value drops from $100, to $99.75, to $99.00. The greater the variance, the more we lose. So when an economist or a mathematician says Risk is costly, they have a rigorous argument supporting and proving the statement.
The financial media runs with this idea but seeks to make it more dynamic. Every day you hear things like “Risk assets suffer today from volatility,” or “It’s a risk-off day as volatility spreads.” These taglines and teases are misleading in multiple ways. First, I often notice that “Risk assets” is a code that means equities, while the phrase “Safe assets” relates to debt. (Remember, when you are told that you “buy” a bond, its really a loan to a government or company that’s borrowing from you because the bank demands a higher return or greater control.) Now the word RISK is being used as though it is synonymous with “volatility”.
Consider 2 scenarios. In Scenario A an index level is 1000, stays unchanged for 2 days, and then jumps to 1002. In Scenario B the level stays at 1000 for 4 days and then falls to 999. Which scenario exhibits more volatility? Clearly, Scenario A is more volatile but this will not be raised as an issue. No one fears “volatility” when prices go up so there is no incentive to broadcast it in that way. You only fear prices going down. In other words, you don’t care about volatility at all. What you react to is a sense of loss. This is the bleeding that leads the show.
There are multiple tricks going on here. First we take a simple word, RISK, and replace it with a word that sounds more scholarly like “Volatility.” Then, we redefine volatility so that it really means variance. Then, we only use it when we refer to changes in one direction. Then, we speak about a temporary fall in price, as though it is a realized loss of wealth. (Remember, no loss is “realized” until you sell the asset. A simple word is translated into spooky language, redefined, only applied in a scary context, as though the worst case is instantly realized. Let me be clear here. I am not saying that any of this is illegal, unethical, or wrong. I am simply pointing out that people tend to do what they are rewarded for doing, and the financial media is rewarded for being alarming and catering to your worst fears.
An Alternate View
When we teach courses like decision theory or game theory, we use a different framework. In these settings we typically think about risk as relating to a bad outcome with both an associated probability and a specified magnitude. There is some chance that a bad thing will happen, and that bad outcome has a measurable magnitude. If you are “risk-neutral” it is optimal to work with expected values, which we can think of as the set of the products of outcomes and their associated probabilities. (We can extend this to consider integrals over probability and payoff distributions, but that extension is not needed for this discussion.) The point is that a likelihood and an outcome are two distinct, but interrelated elements and the term RISK has no meaning until both aspects of the term are accounted for.
Consider two more scenarios. In Scenario C you put $100 into a savings account with a fixed annual return of 1%. In Scenario D you buy my fictitious stock that will pay either -1% or +5% (assume a 50/50 chance). Many people will reject Scenario D because it is “too risky”. There is a 50% chance at a bad (Loss of 1%) outcome. Now let’s account for the fact that the long term average inflation rate in the US is about 3%. In this case Scenario C has 100% chance of a bad outcome, because you are guaranteed to lose purchasing power in this deal. Now let us add that we are going to repeat this payoff stream for 3, 4 ,or 5 periods. Considering all possible outcomes here, the likelihood of ending up better off under Scenario D is, 50%, 69%, and 81% and it will continue to grow (bet never reach 100%) from there. In addition, in period 2, two of the four cases in which Scenario C is better is because 1.03 > 1.029. Thus, we can argue that the relative attractiveness of Scenario D grows as the planning horizon gets longer and it doesn’t have to get much longer than 2 years to become clearly superior.
What’s Your Point
Whenever someone tells you that something is “too risky” you need to find out what they mean by both “too” and “risky.” What does Risk mean in this speaker’s eyes? Is it simply, variance, or “volatility,” or is it more nuanced and has the analysis actually been done, vs. simply repeating a headline. Second, if something is “too” risky what is it being compared to and what’s being left out? Once these elements are accounted for, you begin to understand what we mean when we say that if the plan is to beat inflation, over a 30 year retirement, being out of equity investment is much more risky than being in them.
Let me restate much of this content in a way that is more relevant to the life of the do-it-yourself retirement investor. If you intend to be “safe” for a 30 year retirement period, you are going to constantly wrestle with the burning question of how much of a portfolio will be in bonds versus equities. You will then be constantly bombarded with headlines about how your equities are too risky. This bears a feeling of truth because the variance of their returns are undeniably higher with stocks (That’s why the expected return is higher!). This will be particularly acute whenever “the market” does something you don’t like, like declining by 1/3 in March of 2020. You will be told to run to the safety of bonds in such trying times. At such times we must remember that true RISK is the product of the magnitude of a bad outcome and its probability. If our goal is to fund an inflation-adjusted stream of cash flows over a long period of time, our bond portfolio is extremely risky because the probability if it not keeping up with inflation is almost 100%. Our stock portfolio is almost assuredly more likely to fall next year, but the longer we play this game the more likely the stocks are to deliver a winning hand, and that is the best that we can realistically hope for. At the end of the day the RISK of being out of equities, is far greater than the RISK of being in.
