Risk is a vital concept in investing, yet it’s often misunderstood. For many people, risk is the possibility that an investment might decline in value: for example, the value of equities can go down, sometimes dramatically, so they’re risky. Cash investments such as Treasury bills and high-interest savings accounts do not go down, so they’re risk-free. But what if that’s the wrong way to think about risk?
I use goals-based strategies with my clients, which means I build portfolios designed to help them meet specific financial objectives—such as maintaining their lifestyle in retirement, funding a child’s education, or leaving a legacy. As I see it, the real risk my clients face is not the possibility of losing capital in the short-term: it’s the risk of failing to achieve their goals.
From that perspective, an investor should focus on preserving purchasing power after accounting for inflation. Unfortunately, that requires a long-term outlook that few of us possess. As Brad Steiman of Dimensional Fund Advisors puts it, “investors feel the risk of equities in real time. “The volatility of the stock market appears on their computer screens every day, and it drives home the immediate risk of losing capital. The risk of low-volatility assets, on the other hand, “shows up when investors open their wallet at the grocery store or gas station many years later.”
Let’s look at how this idea should influence your investing strategy. Short-term Treasury bills are often considered risk-free, because they are guaranteed by the federal government and cannot decline significantly in value. From 1900 through 2010, T-bills delivered annualized returns of 4.7% in Canada with remarkably few declines. Equities delivered 9.1% annually over the same period, but to get those higher returns you had to endure a roller coaster of volatility:
Figure 1: Preservation of Capital*
Worst performing periods (nominal returns)
As Figure 1 shows, in the years following the crash of 1929 Canadian stocks lost 64% of their value. By contrast, the worst period for T-bills was 1945, when they still managed to eke out a 0.37% gain. The investor who is focused on preserving capital could be forgiven for thinking T-bills are less risky.
The problem is, the above numbers ignore inflation, which has averaged 3% annually since 1900. When we compare the worst periods for bills and equities after adjusting for annual inflation, the situation is quite different:
Figure 2: Preservation of Purchasing Power*
Worst performing periods (inflation-adjusted returns)
Canadian equities still experienced a difficult period after 1929, with a peak-to-trough decline lasting four years. However—and more importantly—stock prices fully recovered during the subsequent three years. Practically speaking, if someone was unlucky enough to invest in stocks in 1929, just before the Great Depression, they were back to even seven years later, in 1936.
Meanwhile, an investment in cash lost 44% of its real (inflation-adjusted) value during the 18 years from 1934 through 1951. That loss was almost as large as the worst decline for stocks, and it endured much longer. What’s more, after this decline it took another 34 years to recover—in other words, if someone invested in T-bills in 1933, it would have taken until 1985 to break even. I am an advocate for long-term investing, but 52 years is going too far!
Inflation … The Silent Killer of Returns
Inflation is the silent killer of returns: while investors do not see their account balances getting smaller, the gradual rise in the cost living slowly destroys their purchasing power, which is the true measure of wealth.
I understand the desire to park money in cash rather than enduring the turmoil of the stock markets. But it’s important for investors to understand they’re not avoiding risk by doing so: they’re just trading one risk for another. By reducing the possibility of losing capital in the short-term, they are accepting a much lower probability of achieving their long-term goals.
In the end, which choice is really more risky?
*Note: Data are from the Dimson Marsh Staunton (DMS) Global Returns Database, compiled by Marlena Lee of Dimensional Fund Advisors.