By Steven Podnos MD CFP, financial advisors on NerdWallet’s Ask an Advisor
Many tend to view risk as something to be avoided. However, in the investment world, many studies suggest that risk in investing is proportional to return. In other words, you are "paid" to take risk. But, risk in investing is always what it seems, as we often equate risk and volatility.
By delving deeper into this relationship, let’s determine what "risk" really means.
The dictionary defines risk as the “possibility of suffering harm or a loss.” Specifically, to most of us, risk in investing is the possibility of losing money. An examination of investing in equity (stock) markets shows us two different views of risk. It turns out that in the short term, stock market returns are quite volatile, moving up and down as much as 40% in a given year. So there is a "risk" of losing up to 40% of your money during a bad year (if you buy high and sell low).
But a more important observation is that this volatility is markedly reduced over longer periods of time and that a diversified stock market investment held for at least 10 to 15 years is extremely unlikely to "risk" a loss of money. If you have a suitable time horizon to invest in stocks, volatility is certainly not the same as risk.
When thinking about the risk of stock market investments, it is important to compare the major alternatives, bonds or cash-type investments (usually money market funds). The record of the last 70-plus years shows that U.S. stock market returns are about 8 to 10%, bond returns are about 6%, and cash/money market funds are about 3% annually.
Given these observations, the risk of investing in these asset classes looks starkly different. The goal of long-term investing is to preserve, and hopefully increase, purchasing power. If you had received the long-term bond return of 6%, paid tax in a 30% bracket and had the remaining 4.2% reduced by inflation (3%), your purchasing power was very marginally increased by 1.2% a year. If we make the reasonable assumption that bond returns are unlikely to be 6% over the next few years, things would be worse. In fact, at this writing, many “safe,” fixed-income investments have a zero or even negative return after inflation is considered.
You would have lost money after taxes and inflation, year after year, if you had kept your money in cash.
In contrast, a long-term investment in stocks would have markedly increased your purchasing power (4% annually) after taxes and inflation. Stocks offered more than three times the return compared with bonds.
So the "risk" of a volatile return in the short term with stocks is more than compensated for by having a long-term horizon.
When we talk about taking on risk in our investment portfolios, it is important to define the term carefully and consider all the possible alternatives. It is clear that the real “risk” in designing your investment portfolio (assuming a long time horizon) is in not owning a high allocation in stocks and not having the discipline to tolerate volatility.