Larry Swedroe
The Nature of Investment Risk
Larry Swedroe
Wednesday, May 24, 2000
Financial economists generally measure and define risk as standard deviation, a measurement of volatility. A more useful way for investors to think about the risks of investing is that risk is the likelihood of the unexpected occurring.
It is widely acknowledged that stocks provide higher returns than fixed income investments. They do so because investors demand those higher returns as compensation for the greater risks of owning equities. The risk is that equities don't always outperform. In fact, bear markets have historically occurred once every 3 or 4 years (There have been 20 down years for the S&P 500 between 1926 and 1997). In 1973, the S&P 500 dropped 15% and then fell another 27% the following year. On the other hand, even during the Depression, the S&P 500 has never had a period of longer than seven years when cumulative returns have been negative. In the post-war era, that figure drops to just three years. Finally, stocks have outperformed bonds over virtually every 15-year period.
What we learn from these statistics is that when the investment horizon is short, the unexpected occurs fairly frequently. However, the longer the investment horizon, the less likely it is that the unexpected will occur.
These are important concepts to incorporate into an investment strategy. If an investor's horizon is fairly short, he or she should have a relatively low allocation to equities. As the investment horizon increases, so should the allocation to equities. There are two reasons for this. First, as the investment horizon increases, so does the likelihood that equities will outperform the "safer" fixed income alternative. There is also another important reason. As the investment horizon increases, so does the risk that inflation will outrun the returns that fixed income assets provide. In other words, the nature of risk changes as we increase the investment horizon. Equities are risky when the investment horizon is short. However, fixed income assets become the riskier asset class when the investment horizon lengthens.
Investors can put this information to work by using the following table as a guideline.
Investment
Horizon |
Guidelines for Maximum
Equity Allocation |
| 0-3 years |
0% equity |
| 4 years |
10% equity |
| 5 years |
20% equity |
| 6 years |
30% equity |
| 7 years |
40% equity |
| 8 years |
50% equity |
| 9 years |
60% equity |
| 10 years |
70% equity |
| 11-14 years |
80% equity |
| 15-19 years |
90% equity |
| 20+ years |
100% equity |
The above table is just a guideline. For example, investors with a greater tolerance for risk might construct a table that begins at three years and adds 20% per annum. Remember, however, that investors should perform the "stomach acid test," checking their net asset allocation to ensure that their portfolios don't contain too high an equity asset allocation given their tolerance for risk. As Peter Lynch put it in Beating the Street: "Your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed. It isn't the head, but the stomach that determines [your] fate."
Investors should be conscious of the fact that, as the investment time horizon lengthens, they begin to trade one risk (the risk that equities will underperform) for another kind of risk (that inflation will erode the purchasing power of their portfolio). Finding the proper balance is a critical ingredient to the winning the investment strategy. ~
Larry Swedroe is the Director of Research for Buckingham Asset Management. He is author of 'The Only Guide to a Winning Investment Strategy You'll Ever Need,' which is available online.
Copyright, ©, 1998 by Larry Swedroe
Reprinted by permission. All rights reserved.
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