Just How Risky Are Stocks?

There was an article in the WSJ titled Stocks Are Riskier Than You Think. The article was very long and tried to make too many points but there was one particularly useful passage;

If you’re expecting stocks to outperform, say, 70% of the time, you need to think about how much you stand to lose the other 30% of the time. It does not do you a lot of good to have 20 years of great performance, only to be trounced in a crash just before you retire.

A long standing idea is that stocks become less risky the longer you hold them. The basic idea there is with a long time horizon you have more time to recover from a downdraft.

In the last few years I’ve seen where some have turned this around. Stocks become riskier the longer you hold them because everyday that passes brings you one day closer to the next time stocks cut in half. Chances are anyone with a normally allocated investment portfolio in 2007 who was looking to retire in 2009 probably agrees that risk increases over time.

The article appears to question whether or not stocks really do offer the best chance at long term growth. I would say they do except for when they don’t. Over most long periods of time stocks do offer growth, this has been the case and I believe will continue to be the case. In the last decade and change that has not been the case domestically and there have been other similar periods where domestic stocks did relatively poorly and this will happen again at some point in the future.

The experience of Japanese equities since 1989 certainly works against this argument but I’m not aware of any other market that has done so badly for so long.

The realistic downside risk to a well diversified global equity portfolio seems to be around 50%. Certainly any given incident could be larger but the realistic downside risk is not zero. If you own a bunch of index funds targeting different segments of the global equity market they are not going to all go to zero. I would say no single index would go to zero. Also a portfolio of 20, 30, 50, or any other number stocks will all go to zero at the same time.

I’m not sure we know how much a bond portfolio can reasonably drop. The late 1970s was probably the worst bond market we’ve had, but that decline did not start at 0%. Yes with individual bonds you get your principal back but the decline in the meantime can be huge and you are getting yields way below the market when you hold on (the context here is longer maturities).

This makes an argument, in my opinion, for some form of active management. Others would stress asset allocation and I agree that is very important but I don’t think is sufficient by itself. Had the investor mentioned above reduced his equity allocation some in 2007 because he was retiring in 2009 how much would he have realistically reduced by?

You’ve probably heard the term glide path in conjunction with target date funds. While I am no fan of the funds the concept is pretty standard; reduce equity exposure slowly over time. Someone who is retiring in two years at 63, 65 or 67 still has a couple of decades of inflation to worry about and so little to no equities for someone who is not extremely wealthy is not practical.

So I think if anything, the above investor might have gone from 65% to 60% or maybe 60% to 55% so the decline in 2008 would have still complicated the financial plan. Not surprisingly I take this as a validation (or confirmation) for having some sort of strategy for defensive action in a portfolio based on an objective trigger point.

I prefer the S&P 500 in relation to its 200 day moving average but the more important thing is that whatever objective trigger is chosen that it be simple to understand, offer some basis for believing it can work and then that it be stuck to.

Indexing has its benefits but I don’t think there are too many offered in this context. A 50% hit to 50% of your portfolio at a point where you may not be able to hold on all the way through the inevitable recovery would seem like a bad strategy. Using the 200 DMA or any other similar strategy can’t guarantee success but I think it is better than just letting the market happen to you.

About Roger Nusbaum 169 Articles

Roger Nusbaum is an Arizona-based financial advisor who builds and manages client portfolios using a mix of individual stocks and ETFs. Roger writes a popular blog, which focuses on risk management, foreign stocks, exchange traded funds, options etc.

Roger has been recognized by many in the investment management industry for his expertise in portfolio management. Roger has been regularly interviewed by the financial press, trade journals, and television news shows. He has also had numerous technical articles published and has been quoted in a number of professional trade journals, newspapers, and consumer finance magazines. He appears frequently on CNBC Asia as a market commentator.

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