The latest thinking from Greenspring Advisors.

You Are Thinking About Risk All Wrong

J. Patrick Collins Jr., CFP®, EA

Most investors think about risk completely wrong.  They focus on volatility but don't consider their holding period.  As an investment industry  we tend to look at a statistical metric called standard deviation.  That measures how much volatility you can expect with a specific data set.  The problem is that standard deviation is almost always quoted over a one-year period.  But what investor has a holding period of one year?  In reality, most people are investing for 10, 20 or 30 plus years.  What should matter to them is not what volatility their portfolio could experience over one year, but over their entire investing holding period.  Investors only realize losses after they sell.  If they don't have to sell, no losses have actually been realized.  As we have often said, there are really only two days that matter when you invest…the day you buy and the day you sell.  Everything in between is just noise.  As long as that noise doesn't scare you into selling, you can disregard the ups and downs of the market day-to-day, year-to-year.

How can I say this confidently?  I know what the data says.  First, let's look at risk and return statistics of the US Stock Market (CRSP 1-10 Index) from 1926 through September 2015:

  • Average annual return:  12.07%
  • Standard deviation:  21.20%

What that standard deviation statistic tells us is that over 1 year periods we can expect the following probabilities:  

  • 66% of the time we can expect returns to be between 33.27% and -9.13%.  
  • 95% of the time we can expect returns to be between 54.47% and -30.33%
  • 99% of the time we can expect returns to be between 75.67% and -50.53%

No wonder people think stocks can be risky.  Losses can be pretty common and losing a third of your wealth is just something you will probably need to accept at least once or twice in your investing career.  But remember, these are stats over 1 year.  How many of you are selling all your investments within the next year?  Probably not many.  More likely you need your money to last for decades.  So when we look at risk, shouldn't we be looking over your time horizon, not over some arbitrary period like one year?

I re-ran the statistics but instead of 1 year returns, I looked at 20 year returns (annualized):

  • Average annual return:  11.03%
  • Standard deviation:  3.18%

These statistics tell us that over 20 year periods, we can expect the following probabilities:

  • 66% of the time we can expect returns to be between 14.21% and 7.85%.  
  • 95% of the time we can expect returns to be between 17.39% and 4.67%
  • 99% of the time we can expect returns to be between 20.57% and 1.49%

Looking at this data should shift your entire way of thinking about risk.  Stocks really aren't that risky if you can hold them for 20+ years.  In fact, when you look at them over longer time periods, they are even safer than bonds.  For example, Long-Term Government bonds have a standard deviation of 3.51% over rolling 20 years (compared to 3.18% for stocks) and their average 20 year return has been 5.56%, about half that of stocks.

This is why most people should be holding a decent portion of their portfolio in stocks.  As long as they can stomach the year-to-year volatility, their actual risk is quite low when you extend out their holding period. 

*Data take from DFA Returns 2.0 Program