Misunderstanding risk is the major reason people fail to build wealth using equities.
This takes on two forms and most investors are victims of both.
1. We overestimate the long-term risk of owning stocks.
2. We underestimate the long-term risk of not owning stocks.
Tackling and overcoming these two common pitfalls are critical to understanding the investment theory at the center of this book which states:
a. The inflation-adjusted, long-term return of stocks is so much greater than bonds that owning bonds as a tool of building wealth is irrational.
b. Although the ups and downs of stocks are much more volatile than bonds, the passage of time smooths out the bumpiness. We will discuss the concept that volatility (ups and downs of stock prices) is not risk and as time smooths out volatility, the returns of owning stocks remain.
c. The main financial risk that all investors face is not outpacing inflation and therefore suffering a loss of purchasing power. Because stocks, over the long term, outpace inflation significantly the true lifetime risk of stocks is not owning them.
Moving forward some reminders:
1. When I say stocks I am referring to diversified baskets of such using mutual funds or ETFs. I am never referring to owning individual stocks.
2. This book addresses only the accumulation of wealth over the long term, which are investments held 10 years or longer. ie: for your retirement.
Using historical facts, I say:
The risk of losing money from owning a diversified basket of stocks will slowly decline to zero over the passage of time.
Consider the chart below.
In any: S&P Index was positive
1 year period 73.65% of the time
3 year period 82.35% of the time
5 year period 86.74% of the time
10 year period 94.19% of the time
15 year period 99.77% of the time
20 year period 100% of the time
The numbers above demonstrate that as the time sample gets longer, stock market gains become more probable and eventually statistically guaranteed. As most of us are feeling now during the Covid-19 epidemic, time samples of any length will contain volatility. Thus, it is appropriate to discuss the prevailing emotion during a stock market selloff.
Fear causes investors to liquidate equity holdings during a significant market decline when they should be buying quality investments on sale, especially if they have many years of investing left to do.
We must accept that when it comes to equity investing intellect is not the driving factor, emotions are, especially fear.
Richard Thaler famously said:
“Losing money feels twice as bad as making money feels good.”
When the market is slowly grinding upward are you anxious to check your investment balance every day? I would bet that when the market is plummeting rapidly downwards you are very anxious and checking your balance more often than normal. Fear drives this behavior and we are all vulnerable.
Consider this example from the book:
If I lose a coin flip I have to pay you $200,000 but if you lose the coin flip you must pay me $100,000.
Despite the odds of winning and losing being equal and you standing to gain twice as much as you risk losing you will not take this bet. Why?
Asymmetric loss aversion. We fear loss more than we enjoy gain.
Furthermore, and especially in a bear market, we have trouble distinguishing between volatility and loss.
While a market may inflict (temporary) volatility...you, the panic seller, create (permanent) losses by selling.
So how best to handle fear?
While it is normal to feel fear we must not act on it. We must simply refuse. One of the values of a financial planner is to prevent us from acting out of fear when our own nerve waivers.
Finally, if we extrapolate that never selling out of fear means the same as holding stocks for the long-term through all the ups and downs, consider this: Fidelity studied investment accounts between 2003 and 2013 to see which had the greatest returns. The winners?
Account holders who forgot they had an account and those who were dead.
When it comes to long term investing we are often our own worst enemy.
Up next- the risk of NOT owning stocks.