Risk is one of the most elusive concepts in all of investing, partly because so many people define it in so many different ways. That’s okay though, as a single definition probably isn’t sufficient anyway.
One of the most useful definitions of risk is that it’s the probability of something bad happening, and if you want to get fancy, you can include the severity of the bad thing as well.
Uncertainty and risk are often interrelated
You’ll find a lot of risk and uncertainty in the stock market, although it’s not always obvious which is which or how much of either you’re currently facing.
One of the risks that you may not have thought about is the effect that stock market investing can have on your saving rate.
An uncertain pot of gold at the end of the rainbow
Most people are investing so that they can buy something big in the future. This might be a pension annuity or university fees or a McLaren MP4-12C, or perhaps even something frivolous but expensive. If there are 10, 20 or 30 years between now and the purchase date, it’s likely that some money is going to go into the stock market, perhaps all of it, especially given that you’re reading a blog about value investing.
The problem is, even though every pound you put into the stock market is very likely to grow above inflation over 10 – 30 years, you have absolutely no idea exactly how much it will be worth. If the next pound you invest today grows at a nominal rate of 5%, then you’ll have about £4.30 in 30 years’ time. Change that rate of growth to 10%, and you’ll have almost £17.50, more than four times as much.
If the end results are so uncertain, how on Earth do you decide how much to save each month?
Bull markets give the illusion that you only need to save a bit, and the market will do the rest
Another problem is bull markets. During the incredible speculative run-up to the year 2000, many investors sat and watched their pension pots explode upward in value. There are a few different problems with this, but in the context of savings rates, the main one is that some investors reduce their savings rate precisely because the stock market is doing all the work.
They’ll look at the stock market and the value of their portfolio and think about how they’ll be able to retire early and afford two cruises a year instead of one, so why bother to save when the market’s going up 20% a year anyway? In 10 years’ time, they’ll be millionaires.
As many found out, only the lucky few can really take advantage of bull markets. Most people saw their portfolios crushed by the subsequent bear market and the grinding sideways market we’ve had since then. Illusions of a happy retirement are shattered, and years of missed savings opportunities have gone.
Fixed income: High certainty, lower returns but happier investors
A simple alternative is to set up your savings plan on the basis that you want as little uncertainty as possible. That usually means some sort of cash or bond with a fixed interest rate or something that tracks the inflation rate.
If you forget about what you may or may not get on the market and instead think in terms of a fixed and low real return on your investments, then you can start to see how much, in a worst-case scenario, you should be saving to hit any specific goal.
One approach is to assume your real returns will be something like 2% (less than half the market’s actual long-term return), from which you can work backwards from how much you want to accumulate and how long you have to do it to find out how much you need to save each month.
Stocks are not for everyone
The stock market is a very crazy place, and it makes a lot of people who are normally smart do a lot of stupid things. It’s not just that most professional fund managers can’t even beat a simple index, and it’s not just that most retail investors don’t even get the returns of the average fund manager (because they buy last year’s hot fund at a high and sell out low when it inevitably falls); it’s worse than that.
The stock market makes people think they’re going to get rich quickly, whether that be from an index tracker or some nano-cap oil company in Mongolia, and that erodes what is, for most people, the true driver of long-term performance – the amount they save each month.
So if you’re the sort of person who gets carried away with excitement when things are going well or plummets into the depths of despair when things go badly, you might want to re-think the size of your equity allocation and adjust it to the point where you are indifferent to the market’s performance.
This is another reason why I think pursuing income is a good strategy for anyone interested in equities who won’t or can’t commit to just averaging into index funds for 30 years and ignoring the ups and downs.
If you use yield as a metric (across shares, bonds, cash, property and more) then you can withstand a lot of excesses, IMHO.
Hi Monevator. If you mean comparing yields as a rebalancing tool or as a guide to where to put your next saved penny (i.e. dollar cost averaging) then that might not help much. If multiple asset classes are all in a bubble then the signal gets messed up. I think the example that often gets used is Japanese equities being cheap relative to bonds back in the crazy 80s as a way of justifying their lofty valuation.
I prefer to compare yields to the historic averages of the same asset class, i.e. equity yields to their historic average etc, in order to decide if something is expensive or cheap and therefore whether the allocation should be high or low. That makes more sense to me but I don’t know of any empirical studies that say one is better than the other.