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Lessons of Market Risk

Risk. At first glance, such a simple word, easily understood. After all, it’s there in just about every decision we make. From when to cross the street, to where to send our kids to college, we weigh the trade-off between the threats involved against our hoped-for rewards. In investing, there are several kinds of risk that come into play. Let’s explore the multi-faceted world of financial risk, and how an improved understanding can help you make better investment decisions.

Unexplained Market Risk

You probably don’t need to be told that investing your hard-earned money in the stock market entails some risk. But it’s important to also be aware of the academic evidence on how market risk has played out over the long-term. Some kinds of market risk are necessary means to your financial end. They are academically explained, and expected to compensate you for accepting them. Others have remained unexplained, with little or no expected reward for accepting them.

A good analogy I’ve heard for taking on this type of unexplained risk is that it’s like trying to cross a busy highway on foot — when a pedestrian bridge is just up the road. High danger for little added value. Why would anyone do that? Maybe the bridge is hidden around a curve.

It seems a given that unexplained risk is best avoided. And yet most investors routinely allow unexplained risks into their portfolios. Maybe they’re unaware that they don’t have to. Ample academic evidence tells us that the vast majority of a portfolio’s returns is explained simply by the risk factors within the broad asset classes you hold, such as riskier stocks versus safer bonds, and riskier versus safer stock classifications. Only the tiniest sliver of return variation is explained by attempts to make savvy individual stock selections or place timely trades in reaction to market or economic forecasts. Here’s the visual for that

Structure Determines Performance

In other words, taking on the risk of stock picking or market timing (along with their related costs) is the equivalent of trying to dash through the markets without getting hit, when the bridge to your personal financial goals can be built more effectively by investing in mutual funds that focus on maximizing disciplined asset allocation and minimizing the costs involved.

Which takes us to the concept of priced risk.

Priced Market Risk

Make no mistake. Priced risk is still real risk; returns are never guaranteed. Stock prices can plummet or soar without warning. In financial-speak, this is called volatility (or sometimes “standard deviation,” which is the measure of the volatility). And, yes, volatility represents real risk. If your investments dip alarmingly low, you wouldn’t be human if you didn’t grow frightened and wonder if you should “do something.” Investors routinely panic and sell while prices are low; then try to buy back in, usually when the price is high; and end up hoping for the best instead of adhering to a plan. Whoops, now we’re back to accepting that unexplained risk.

Here’s the secret: the priced risk factors illustrated in Figure 1 can be scary, but they are expected to give you exposure to the market’s premium returns. In other words, they’re the calculated risks that you must take if you hope to receive the reward.

That’s not to say you should bulk up on the riskiest kinds of risky stocks for your entire portfolio. Over the long-term, the market has delivered premium returns in measure with the priced risks taken. But there can be long, severe periods where this just isn’t so. For that reason, we recommend building a portfolio that balances the risks you need to take with a safety net of fixed income (bond) holdings, to sustain you during those times when the risk plays out.

This leaves us with one final risk factor to discuss. The “risk” of those safe holdings.

Inflation Risk/Purchasing Power

If the stock market is such risky business, why not just stick all your money under the proverbial mattress? There may be rare circumstances when an investor has so much wealth and/or such a short time horizon that this strategy might make sense. But for the vast majority of us, there is one more risk factor to be aware of. Inflationary risk impacts the purchasing power of your money. The things that $1 will buy you today are highly likely to cost more than $1 eventually. Postage, gas prices, bread, yachts. Prices go up more than they go down — to the tune of roughly 3 percent historically. In other words, if your $1 saved isn’t likewise earning about the same after-tax return over time, you’re actually losing money. Think of it as the hungry mouse that’s hiding under your mattress along with your money. How much growth you may need or want beyond inflation determines how much calculated market risk you may need or want to accept into your portfolio.

Which leads us back to the value of achieving balance in your investment strategy. Form a plan that balances your priced risk factors and their expected rewards with a measure of risk-free holdings. Eliminate unexplained risk by diversifying your holdings across our global markets. Seek mutual fund solutions that minimize the costs involved in the effort. Stick to the plan. These are the lessons of market risk.