Understanding Your Risk Tolerance as an Index Investor

As an investor, you are confronted with numerous risks. Most of the literature that I have read suggests that index funds are the best way to diversify in order to reduce risk. The investor gets the added benefit of low fees and little cost in form of commissions. I think this is practical advice for most investors.

As our recent bull market is over 8 years, it makes it the second longest run in history. This is next to the bull market of the 1990’s.  For those who weren’t invested around 2000 or 2008, I think it is practical to review the indexing strategy during down years to verify your real tolerance for risk.

It is necessary to understand your investing goals and your required duration to truly know your risk tolerance. Is your investment earmarked for a home purchase in a few years? Maybe it is for your retirement 30 years and you are comfortable with any short-term losses in order to benefit from the superior returns common stocks can bring. No matter your goals, it should be helpful to understand what is at stake.

As an index investor, you are faced with market risk. You may mitigate a specific business’s risk by diversifying across the broader stock market. However, market risk is not easily avoided by diversification within the stock market.

A correction or collapse could happen at any moment.  No-one really knows when this will occur, although there are plenty of people making predictions all the time.  There are many reasons for a market collapse. During a collapse, usually no sector is off limits.  Some reasons we have seen a collapse in the past are a tightening of credit, a political issue, a natural disaster or war.

My intention with this data isn’t to scare you out of your investments; it is simply to help you understand your risk profile and try to envision what you would do when panic arises.  I would hope you would hold on, or better yet add to your investments.

As an investor, it is your obligation to understand your risk profile to appropriately diversify to other asset classes.

Turning Point Money Disclosure

In full disclosure, I invest in index funds primarily in our retirement accounts (in addition to fixed income.) In our taxable accounts, I am much more active and invest in individual securities. I think for most investors they will do better with index funds. However, three primary reasons why I invest in common stocks are:

  • Investing is my hobby. I measure my performance against benchmarks and attempt to outperform the usual investing benchmarks. I have always been a bit of a gambler, but only when I think I have an advantage. Back when I was pursuing my master’s degree I won many poker tournaments.
  • Active Investing allows me to personally select what I feel will provide the best risk adjusted returns
  • Active Investing helps me achieve my goals for my taxable portfolio. Overtime this portfolio will be used as income to pay for our monthly expenses. A far greater yield can be generated from your investments than what he S&P is currently providing at 1.91%, with potentially less volatility than the S&P 500 index

A Random Walk

One of the first books I ever read on investing was A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing, by Burton Malkiel. My version is older, but they keep updating this book over time. If you have not read it, the book is a classic and covers many topics of investing including Efficient Market Hypothesis.

The reason I bring up this book is because the author did some analysis on the returns of the common stocks versus Treasury Bills and 10 year Treasury Bonds. I think this comparison is helpful. I wanted to look at this data, but more with my investment lifetime in consideration. I do care what happened historically, but I wanted to see the relevance in a more current time period. The author was looking back to 1926.

I found some data provided by NYU Stern found here. I arranged the data and looked at 1 year, 5 year, 10 year and 15 year cumulative annual returns for my lifetime and my investing lifetime; 1980-2016 and 2002 – 2016 respectively.

1980 to 2016 2002 to 2016
Investment 1year 5year 10 year 15 year 1year 5year 10Year 15year
S&P 500 Best Cum. Return 37.20% 28.29% 19.04% 18.80% 32.15% 17.72% 7.61% 6.62%
S&P 500 Worst Cum. Return -36.55% -2.32% -1.36% 4.19% -36.55% -2.12% 2.88% 6.62%
S&P 500 Average Cum. Return 12.88% 11.45% 10.80% 10.75% 8.27% 7.34% 6.50% 6.62%
3mo. T.Bills Best Cum. Return 14.30% 10.90% 8.81% 7.42% 4.68% 3.02% 1.80% 1.26%
3mo. T.Bills Worst Cum. Return 0.03% 0.08% 0.73% 1.26% 0.03% 0.08% 0.73% 1.26%
3mo. T.Bills Average Cum. Return 4.61% 4.26% 4.22% 4.17% 1.27% 1.39% 1.38% 1.26%
10 yr. T.Bonds Best Cum. Return 32.81% 19.49% 13.67% 12.07% 20.10% 8.17% 6.49% 4.67%
10 yr. T.Bonds West Cum. Return -11.12% 1.12% 4.27% 4.67% -11.12% 0.92% 4.27% 4.67%
10 yr. T.Bonds Average Cum. Return 7.95% 8.12% 7.97% 7.83% 5.01% 4.78% 5.04% 4.67%

Single Year S&P 500 Returns

For the S&P 500, it should be of no surprise that the longer your duration, the better the outcome you can expect. Said differently, the longer you hold common stocks, like an S&P500 index, the better risk mitigation you have from negative annual returns. If only hold for one year you may lose a substantial portion of your invested capital. On the other hand, you may be rewarded handsomely for the risk if you time it correctly. In 1995 you would have seen a one-year gain of 37.2%. In fact there were 14 years of a single year returns over 20% from 1980 to 2016. That is almost a 38% chance of over a 20% return for the last 37 years.   This is not bad news for S&P 500 indexers.

However returns like this come with considerable risk. Can you handle a 36.55% loss for the year or maybe even worse?   There were six years over these 37 years with negative returns for the S&P 500. Three of them were doubled digit percentage losses. There are also times during the mid-year when the losses could have been substantially larger during the correction and subsequent recovery. What would you do?

Five Year S&P 500 Cumulative Returns

Could you imagine a five year cumulative return of 28.29%? The lucky folks that bought in 1994 and sold at the peak in 1999 were very happy with their results. Unfortunately, many did not sell.

If you look at the five worst cumulative annual returns for 1980 to 2016 you would have lost 2.32% per year. In this unfortunate example, you would have bought in 1999 and sold in 2004.

Do you have the temperament to ride out losses over five years?   Would you question the indexing strategy?

Ten and Fifteen Year S&P 500 Cumulative Returns

As we look past short duration index holding (in my definition – less than five years,) you begin to notice that the risk of losing capital vanishes. Depending on the time period, the holding periods for the S&P 500 for long term holding (ten or fifteen year duration) usually outperforms the ten year Treasury bond except for recent years.  The bolded percentages represent the greater growth rate.

The difference of a few annual percentage points can equate to millions of dollars of capital gains over an investor’s lifetime.  If you have goals of financial independence or to retire early, those few percentage points that common stocks provide could make the difference of years added back to do whatever you please.

Year S&P 10 year CAGR S&P 15 year CAGR T.Bonds 10 Year CAGR T.Bonds 15 Year CAGR
1979 – 1989 17.34% 11.96%
1980 – 1990 13.80% 12.98%
1981 – 1991 17.41% 13.67%
1982 – 1992 16.08% 11.49%
1983 – 1993 14.85% 12.62%
1984 – 1994 14.32% 14.36% 10.25% 10.29%
1985 – 1995 14.83% 14.67% 10.06% 12.07%
1986 – 1996 15.23% 16.62% 7.84% 11.59%
1987 – 1997 17.90% 17.40% 9.42% 10.19%
1988 – 1998 19.04% 17.77% 10.08% 10.99%
1989 – 1999 18.05% 18.80% 7.38% 9.41%
1990 – 2000 17.30% 15.93% 8.39% 8.87%
1991 – 2001 12.81% 13.67% 7.46% 7.69%
1992 – 2002 9.26% 11.38% 8.01% 9.07%
1993 – 2003 10.96% 12.10% 6.63% 8.53%
1994 – 2004 11.95% 10.83% 8.00% 7.67%
1995 – 2005 8.98% 11.41% 6.04% 7.44%
1996 – 2006 8.33% 10.53% 6.10% 6.58%
1997 – 2007 5.84% 10.39% 6.13% 6.63%
1998 – 2008 -1.36% 6.41% 6.59% 6.99%
1999 – 2009 -0.95% 7.97% 6.26% 6.75%
2000 – 2010 1.38% 6.69% 5.49% 5.83%
2001 – 2011 2.88% 5.40% 6.49% 6.78%
2002 – 2012 7.03% 4.43% 5.31% 6.32%
2003 – 2013 7.34% 4.63% 4.27% 4.67%
2004 – 2014 7.61% 4.19% 4.88% 5.99%
2005 – 2015 7.25% 4.95% 4.71% 5.00%
2006 – 2016 6.88% 6.62% 4.58% 4.67%

10 Year Treasury Bonds

Now looking at the bonds, I noticed that in my investing career, bond returns have been mostly lagging the returns of the S&P, up until recently when we had some very down years in common stocks.  However, I believe a properly diversified portfolio should include a bond allocation to help weather the occasional erratic swings of common stocks.

The downward yearly swings have been minimal for treasury bonds. In the 37 years from 1980 to 2016, there were only 5 years of negative annual returns with the worst coming in 2009 for a negative 11.12%.

Treasury Bill’s

For 3 month treasury bill’s, your risk of losing capital never occurred in this time horizon. In fact, if you look at the full data set that dates to 1928 you would have never lost capital. However your rate of return would have been paltry compared to common stocks. This is usually an appropriate place to hold short duration money. Always consult with an investment advisor, but I have used treasury direct in the past.

Conclusion

Understanding that a downturn can happen at anytime and could be greater than 30% loss should be cautionary to investors who have not lived through the 2008 or 2000 recessions. Substantial risk of capital losses may happen at any time and could occur very quickly. Capital losses could take over five years or longer until you recoup your original investment. This is the burden you must accept to reap the superior gains for common stocks.

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