Financial literacy studies find a significant deficiency in the population’s understanding of investment risk.
And fair enough, investment risk is not an easy topic to understand. It took me six years to understand it well.
This is a problem.
Successful investors avoid excessive risk and survive market downturns (while extreme risk-takers implode). But they are not so risk-averse as to hold life savings in cash for the next 30 years.
Here are some questions that you can’t answer without understanding investment risk:
- What’s the probability that I can retire off my investments at a specific age?
- Should I put my money in 100% stocks if I want to buy a house in 3 years?
- What is the probability that my investments will be able to fund my kid’s education?
- Why does Jake recommend I avoid stocks if the money is needed in the next 5 years?
The aim of this post is to help you understand risk for the three main assets: stocks, bonds and cash.
Table of Contents
What Is Risk?
Risk is uncertainty in returns.
Please read it one more time. I link back to this foundational definition throughout this post.
This definition stems from some (heated) conversations with my girlfriend. She is wrapping up her Canadian Risk Management (CRM) designation.
On a side note, she is also my “editor-in-chief.” She often corrects my inner engineer, who has limited grammatical aptitude.
Assets Assessed and Inflation
To highlight risk, I use run simulations of investment outcomes at PortfolioVisualiser.com for the following assets:
- Cash-earning interest (at the risk-free rate) in a money market fund.
- A 100% bond global index portfolio, USD hedged.
- A 100% stock global index portfolio, 50% US market, 50% global ex-US market.
Inflation
All of my plots and returns are in inflation-adjusted terms.
This provides a more accurate view of your future purchasing power, which I’m sure you care about. It would feel wrong to ignore inflation.
To transform my inflation-adjusted returns into “before-inflation” returns, add 3%.
For reference, inflation-adjusted returns are called “real” returns,” while returns before inflation are called “nominal returns.”
How To Measure Risk
Return uncertainty can be measured through the dispersion of returns among the mean. This is measured through the standard deviation.
In the graph below, the standard deviation measures the curve’s width. The peak of the curve represents the average (mean) annual return.
As you can see, the standard deviation is high for stocks, moderate for bonds and low for cash.
A narrow curve, like the green one for cash-earning interest, indicates that you will likely receive a return close to the average. For reference, the average real return for cash over the past 122 years is 0.7%.
The curve for bonds is broader, showing higher uncertainty in returns among the mean relative to cash. Over the past 122 years, the average real return for bonds was 2.0%.
Finally, stocks have the highest uncertainty in returns, as reflected by the width of the yellow curve. As expected, stocks also have the highest average return, at 5.3% over the past 122 years.
Risk is uncertainty in future returns. As risk increases, so do the expected returns.
Average returns are pulled from the Credit Suisse Investment Returns Yearbook. The standard deviation data from stocks and bonds is from PortfolioVisualizer.com.
Note that I reduced the standard deviation for stocks to permit nice visuals on my plot. The actual curve is even flatter with a higher standard deviation.
Risk In The Long-Term and Short-Term
In the short term, uncertainty in returns shows up as the swings in ups and downs in the investment price. This is called volatility.
Volatility is evident in the short term, but what about a long time horizon? In the long term, volatility looks like it is dampened, but the definition of risk doesn’t change.
The definition of risk is still uncertainty in returns. This is true over five days or 30 years.
I show that stocks remain riskier than bonds and cash over long time horizons.
Finally, I show that risk is not the same as the probability of losing purchasing power.
Risk In The Short-Run: Volatility
Uncertainty in returns shows up as short-term volatility in the short-term. Volatility looks like the intensity of the ups and downs of an investment’s price.
Check out these one-year charts for a stock fund (small-cap value fund) and a short-term bond fund. With these charts, you can see the differences in volatility.
The stock fund above has some wild variations. It swings from $65 to $83 in just a few months. Turned into a percent, these equate to 20% swings, a high standard deviation.
In 6 months from now, you may be up 20% or down 20%. Who knows. You have low certainty in your future returns. The risk is high.
Now check out the short-term bond fund. It’s top-to-bottom swing is no more than 5%.
The bond fund has lower volatility, measured by a lower standard deviation. It provides higher certainty in returns.
It is worth noting that 2022 was one of the most volatile years for bond funds due to aggressive rate hikes.
In the short term, volatility is a good measure of uncertainty in returns.
Let’s take a look at a $10,000 initial investment over a two-year time horizon with the three different portfolios I described above:
- An index stock fund
- An index bond fund
- A money market fund.
Two Year Volatility: Global Stock Index
Stocks are volatile over two years. With $10k invested, there is an 80% chance that your wealth will lie between $14,600 (21% annual return) and $7,800 (-11.7% annual return).
Over these two years, there is high uncertainty in returns, and about a 30% probability of loss in inflation-adjusted terms.
Two Year Volatility: Global Bond Index
Now take a peek at the outcomes for a global bond index.
With a $10k initial investment, you have an 80% chance of end wealth falling between $11,467 (7.1% annual return) and $9,494 (-2.5% annual return) after two years.
Over these two years, returns have moderate uncertainty. There is a 25% probability of loss in inflation-adjusted terms.
Two Year Volatility: Money Market Fund
Money market fund outcomes are tight, providing high certainty in end wealth. As you can see, you have an 80% chance of ending wealth falling between $10,600 (3.0% annual return) and $9,650 (1.8% annual return).
The range of outcomes depends on inflation and the interest rate environment.
Stocks have the highest uncertainty in returns when looking at two year periods.
In addition, the probability of losing purchasing power over this period is highest with stocks, moderate with bonds and lowest with money market funds.
The probability of losing purchasing power (negative real returns) changes over longer time horizons, as you will see shortly.
Risk In The Long-Run: Uncertainty In End-Wealth
It’s time to examine the possible outcomes of a $10,000 initial investment over 30 years. I will assess this for stocks, bonds and cash.
Have you ever heard the statement “Stocks become less risky over the long-term”?
I’m afraid I have to disagree. Keep reading to see why.
30 Year Outcomes: Global Stock Index
At the end of 30 years, in the best 10% of cases, you end up with $175,000 or more (a 10% real return). In the worst 10% cases, you have $15,000 or less (a 1.4% real return).
That’s a massive dispersion in long-run returns. Therefore, the risk is high. Expected returns are also high.
Global stocks returned 5.3% annually over the last 122 years. Remember, that’s inflation-adjusted. For nominal returns, add another 3%.
Stocks provide high uncertainty in returns. This is true in the short term and it’s true in the long term. Despite being risky, stocks have a low probability of losing purchasing power over 30 years.
30 Year Outcomes: Global Bond Index
Bonds provide a smaller dispersion in the end wealth relative to stocks but with lower returns.
Over 30 years, a bond portfolio has an 80% chance of returning between 1.1% and 3.5%.
At the end of 30 years, in the best 10% of cases, you end up with $28,405 (a 3.5% real return). In the worst-case 10% of cases, you would have $15,000 or less (a 1.1% real return).
For reference, global bonds returned 2.0% annually over the last 122 years.
Therefore, bonds are less risky than stocks. Note this is coherent with the definition of risk in the short term.
30 Year Outcomes: Cash In A Money Market Fund
Consider cash-earning interest. At the end of 30 years, in the best 10% of cases, you end up with $14,300 (1.2% real return). In the worst 10% of cases, you end up with $9,700 (-0.1% real return).
This reflects a small dispersion in annualized returns. Therefore, the risk is shallow.
Note the higher probability of inflation-adjusted loss relative to stocks and bonds.
Risk is the dispersion in returns. In the long-term, this is different than the probability of losing money!
In summary, stocks remain risker than bonds and cash in the long term – higher uncertainty in returns.
Over a 30 year period, you have an 80% probability of an annualized real return in the following ranges:
- Stocks: 1.4% to 10%
- Bonds: 1.1% to 3.5%
- Cash: -0.01% to 1.2%
Risk In The Long Term: Loss Of Purchasing Power
Risk is uncertainty in returns. This definition works in the long term and the short term. Therefore, investment risk is not the same as the probability of losing purchasing power.
In the short-term, high-risk assets like stocks swing around. There is a higher chance of losing purchasing power relative to cash or bonds. But things change in the long term.
Risky assets like stocks have a low probability of losing purchasing power in the long term relative to bonds or cash.
For example, scroll back up, and you will see that stocks have the highest chance of retaining purchasing power over 30 years of all three assets assessed.
Perhaps this helps you overcome your fear of investing.
From Investment Risk To Your Goals
Understanding investment risk can help you understand the risk associated with your financial goals.
Consider George, a 20-year-old who wants to reach financial independence at age 40. George has a 100% global index stock portfolio.
He relies on a 5.3% real return (8% before inflation) to reach the target portfolio value needed to produce investment income to cover his expenses. Note that safe withdrawal rates were a key component of George’s planning.
Since George read this post, he knows there’s a 50% chance of receiving a 5.3% return over the next 20 years.
After reading this post and running a Monte-Carlo simulation at PortfolioVisualizer.com, George has realistic expectations regarding the risks to his early financial independence goal.
Investment risk is critical to setting and meeting your financial goals.
Conclusion
Risk is uncertainty in returns. This produces uncertainty in end-wealth. Over long time horizons, small changes in returns can have massive effects in end-wealth. You can thank the compound effect for this.
Stocks are riskier than bonds, and bonds are riskier than cash-earning interest. As risk increases, so do your expected returns.
Furthermore, I showed that risk is not the same as the probability of losing purchasing power. Stocks are risky in the short term and the long run. There is no paradox!
I hope this enables better investing decisions.
Consider joining the newsletter for more posts like this.
Jake out.
