As we begin our lifelong investing “career” we must recognize the risks inherent in investing. A primary risk for investors accumulating the funds for their retirement years is that they fail to accumulate a nest egg that can outpace the cost of living.
In attempting to garner positive real, after-inflation returns, investors tend to rely on the long-term historical return of asset classes, and harbor a hopeful expectation that the future will offer similar long-term returns.
The 1900 – 2013 performance of globally diversified investment markets shows that the global markets have provided positive real returns. Historically, the markets have offered investors compensation for bearing risk, as equities have realized premium returns over bonds; and bonds have offered premium returns over bills.
- The world risk premium for stocks over bonds was 3.40%.
- The world risk premium for bonds over bills was 0.90%.
- The world risk premium for stocks over bills was 4.30%.
- Although some nations have realized better historical performance than others, and we can expect differences in future returns, we can have no assurance of exactly which national markets will be relative winners or losers going forward.
- Investing globally can diversify the risk that one’s home market will offer poor future returns.
Stocks give us a share of the profits generated by publicly owned companies in the economy Investors own stocks in the hope that the expected premium return will be realized to provide the needed funds for retirement. But in exchange for the hope of high return, stocks are extremely volatile and risky. Stock prices can stagnate or decline for decade-long periods The chart below shows U.S. stock market performance (1929 – 2011) as measured by the S&P 500 index. As seen, the long-term upward trend is punctuated with periods of extreme losses. These periods can result in:
- Investors abandoning the stock market during the depths of the downturn, thus locking in the loss. The emotional scars can lead to an investor deciding to never again invest in stocks.
- Note that many bear markets accompany economic recessions. In recessions you might lose your job or suffer reduced income. You might need to tap your investments for living expenses, thus forcing a sale at market lows.
- A severe bear market occurring as you approach retirement or are entering your retirement years can either delay your retirement, or greatly reduce your portfolio’s ability to provide a sustainable life-time income.
It is easy to underestimate stock market risk and to overestimate your tolerance for risk If you have not been through a major market downturn before. Your logical considerations of risk can quickly become emotional ones.
The middle vertical bar represents the range of annual returns on 10-Year U.S. Treasury Bonds over the 1928 – 2013 time period. Note the range (dispersion) of returns–from about -11% to +33%. Also note the average annual return of 5%. Bonds are a promise to pay back a loan of money on a pre-set schedule. Bonds do not produce the same expected high returns that stocks do, but they are much less volatile. (see table to the right). Inflation is a large risk affecting nominal bonds. For US bonds, two periods of extreme duress occurred from August 1915 to June 1920, when treasury bonds provided a -51.0% real return. Bonds recovered the loss in August 1927. Treasury bonds lost -67.0% in real value from December 1940 to September 1981. Treasuries recovered the loss in September 1991. Investors holding balanced portfolios of stocks and bonds experienced lower draw downs and experienced shorter recovery periods in real value. For example, Vanguard research shows that a 50% U.S. equity/ 50% U.S. bond portfolio has produced annualized real returns of 5.26% during economic recessions and annualized 5.59% annualized returns during economic expansions. Note however that the historical averages mask recessionary periods when returns for this allocation were negative. These periods include the Great Depression; 1937; 1973; and the 2008 financial crisis. During these periods real return annual losses ranged between -5% and -15%. The way to get reasonable growth without stomach-churning drops is to hold a mix of stocks and bonds.
- Bond real returns comes from the Dimson, Marsh, and Staunton,Credit Suisse Global Investment Returns Yearbook 2011
- The Vanguard paper, Davis, Joseph, and Piquet,Daniel, Recessions and balanced portfolio returns Vanguard Research, October 6, 2011 (link available with google search).
Next post in the investing basics series: Diversifying investments