How to Invest With Less Risk

 
 

YOU CAN'T AVOID RISK - IN FACT, YOU NEED IT

In my experience, the number one reason people haven't started investing is because they are afraid of risk, and don't correctly understand its role in investing. Naturally, we are afraid of things we don't understand.

During the Great Recession in late 2007 to early 2009, many people experienced what it's like to see the value of their investment portfolio drop significantly in a relatively short period of time. 

These kinds of experiences, if not properly understood, can make you risk averse. You don't want to become like that. If you don't invest at all because you don't want to take on any risk, guess what? You're still taking on major risk. It's called inflation risk, meaning the general increase in cost of living and prices of goods and services will outpace your ability to save enough money for the future. All investing takes risk, and if you don't want to take on any risk, you can just plan on never retiring.

That's why investing too conservatively (or not at all) is not going to work. 

In order to retire and reach other financial goals, you need your money to grow faster than what you can accrue by merely saving it. The only way to do that is to invest your money so you can earn a higher return, but there is always the inevitable truth that investing takes risk.

So embrace it, and let me help you absorb a sound, fundamental understanding of risk.

LOSS AVERSION

To be clear on what I mean by "risk", I'm referring to the possibility that you could lose all your money in any given, single investment. 

Everyone is afraid of putting money into an investment and losing some value, or in the most extreme cases, losing ALL of it. There are several types of investing risks, but regardless of why it happens, it's the risk of losing money that hurts the worst.

Did you know that we experience the pain of loss twice as strongly as we experience the pleasure of gain. We're hard-wired toward what psychology calls loss aversion.

From this fear comes the proverb "don't put all your eggs in one basket."

If you invest all your money in the stock of a single company, then you are completely tied to the fate of that company. If the company does well, they will make profits, and there are essentially two ways you can make money. The first is through receiving dividends, which is basically a proportionate share of profits sent to you by the company since you're a part-owner as a stockholder. The second way is through a capital gain, where you sell the stock for more than you bought it for.

If you're invested only in the stock of a single company and it does well, all is fine and dandy. However, if the company goes down...you go down.

You can't possibly know all the factors that might affect a company. You could research a company extremely well and feel very confident that it's going to have solid and reliable growth. But any number of events could bring that down overnight that you can't possibly anticipate perfectly.

CLASSIC EXAMPLES OF INVESTING RISK

Here's a brief look at some companies that were supposed to be invincible but have met or nearly met their demise:

  • Remember the Palm Pilot? There was a time when the Palm Pilot was the future. As we all know, it was obliterated almost overnight by the release of the iPhone and the dawn of the smartphone era. Palm Inc. was no more by 2010, when they were bought out. Goodbye.
     
  • Or Enron, a company in the gas/oil/energy industry, which is an industry that's never going to NOT make money, right? They disappeared in possibly the most famous scandal in history when it was discovered they were exaggerating their profits through accounting and audit fraud. Hasta la vista.
     
  • Sears and Kmart, retail store legends that we all pretty much accepted were going to be eternal mainstays - companies that would live forever. I mean, the Sears Roebuck catalog is like a part of American history! Both of these companies had to merge with each other just to stay alive over 10 years ago, and they close so many stores each year it's not even funny. The onset of Walmart in the 1990's and the rise of Amazon in the 2000's can be thanked for that. (Anticipatory) farewell!

So, if you haven't adopted the idea already, I'm trying to support the well-backed idea that trying to pick single stocks exposes you to a lot of risk. 

How do we solve the risk inherent in investing? The Big "D", and you've probably heard of it before:

"D" IS FOR DIVERSIFICATION

Diversification is so simple in concept, but few apply it correctly. At a base level, it simply means putting your money into several different types of stocks, bonds, and other investments to that you are spreading out your risk. 

If you buy several different investments, you're protected against the bad performance of any single investment. Even if one of them does poorly, several others will be doing well, cancelling out that effect. History shows us that even though individual stocks (and even the entire stock market) fluctuate up and down over time, when looked at over a long-period of time, it has always been on the rise. A well-diversified portfolio, or collection of investments, is going to increase in value despite some fluctuations in short-term periods, because you'll have more "good" performers than "bad" performers over time.

This makes perfect sense conceptually to most people, but actually putting it into practice is a completely different matter.

While it's impossible to give a comprehensively detailed explanation in one sitting, here's a basic rundown.

ASSET CLASSES

We can group investments together into different categories, based on similar characteristics. We can call these categories asset classes. Then, we can look at how these asset classes "behave" in relation to each other - their correlation.

As the economy goes through cycles, different parts of the economy are affected in different ways. Companies of similar types will have their stock prices move similarly with each other. For example, some industries, like food and hygiene products, won't necessarily struggle in a bad economy; people will always need those things, so those companies might continue to show steady profits and their stock prices may stay stable regardless of the economy's state.

But if unemployment is high, times are hard, and there is less money to go around, do you think very many people are buying new cars or have the spare cash to buy gadgets and premium electronics? Probably not. Those companies will probably be struggling to show consistent profits, and their stock prices might suffer as a result - people won't be willing to pay as much for their stock.

Here's another example: just because the U.S. economy is struggling, does that mean that countries in Europe or Asia are struggling in the same way or same amount? Not necessarily. Look at this diagram, showing the growth of $10,000 between 2000 and 2016. The blue line is US Stocks, the red line is European Stocks, and the yellow line is Pacific Stocks (meaning the developed countries of East Asia like China, Japan, Korea, and Hong Kong).

As you can see, you could take a snapshot at several different points along the way and have a different "winner". In 2002, US Stocks (blue) would have had the highest value, but between 2004 and 2012, European Stocks (red) would be highest - and in 2008, by a large margin! But do you see how far it dropped from 2008 to 2009? For a long stretch, 2006 to 2011, US Stocks and Pacific Stocks were neck and neck. By 2016, US Stocks outpaced everything again and now would sit well above either of the other two categories.

And herein lies the most common mistake in trying to diversify: it's not just about buying a hundreds of different stocks. It's about buying hundreds of investments that are different from each other. In this case, most of the large companies in America go through the same patterns as the economy runs through its cycles.

(Please note that I have only picked three major asset classes among tens of the main ones out there, and I've picked a somewhat arbitrary time-frame of the last 16 years. There are countless combinations of time-frames and asset classes that will show vastly different results)

Also note that the graph above only shows what would happen if you invested a $10,000 lump sum all at once in 2000 and left it there for 16 years. While that approach is an acceptable way to compare different asset classes if we're curious about their comparative performance to each other in a certain time period, that's not how people invest in real life. In real life, you are most likely investing a fixed amount on some kind of regular basis (monthly, quarterly, or annual) and that would change the way the graph would look.

The important thing to understand is that asset classes "behave" differently from each other. Clearly, their prices don't all move together in sync. When one "zigs", another will "zag." Each asset class, at some point in time, may have the most dramatic drop, and at another time the most dramatic rise.

No one knows exactly how and when the economy will change; we also can't predict exactly how a single investment or asset class is going to perform in the short-term. Instead, by owning several different asset classes (diversification) you can benefit from the general long-term growth of the investment market.

Looking at it in more detail, we will see how that helps us on an emotional level as well.

DIVERSIFICATION SMOOTHS OUT VOLATILITY

In the investment world, risk is largely assessed by volatility - this is how widely an investment's return varies over time. As we know, there can be some years where an investment's return is flat, others where it is negative, and others where it is positive. And these "swings" can be moderate or large in degree.

Regarding volatility, all the research points to one fact about investors: it's during the times of highest volatility that we majorly shoot ourselves in the foot. We can't bear that our investments have "dropped" so much in value, and we are at risk of "selling out" - meaning when you sell your investments at the currently low price of a market crash, and then miss the growth that happens when the market rebounds because you don't own the investments anymore. This is, effectively, selling low and buying high instead of buying low and selling high.

The beauty of diversification is that instead of trying to play the losing game of "which stocks will go up when?" and "only picking investments that go up" (no such thing), you buy a wide spread of asset classes and accept that there are always going to be some of your investments that are over-performing and others that are under-performing. But overall, you'll get to ride the general growth of the market but also get the comfort of a smoother ride. Your overall portfolio won't fluctuate so widely, which reduces the amount of anxiety you feel and, consequently, lowers the chance that you'll "jump ship" and sell your investments low.

To drive the point home, let's look at one more chart (it'll be worth it, promise!).

  1. The blue line represents the S&P 500, which is basically the 500 largest companies in America. I chose this one because I hear so many people say they don't want to invest in anything except this because they want "companies that will never go out of business and will always do well."
     
  2. The red line represents people who don't want to take on any risk, and only "invest" in things like CD's or interest-paying savings accounts.
     
  3. The yellow line represents a diversified portfolio split among large US company stocks, small US company stocks, stocks from international companies all over the world, real estate, and several different bonds. (Note: this is just a basic example of what diversification can achieve; it still is missing some asset classes and is in no way what I would call a perfect or ideal portfolio)

As you can see, the red line is stable but got hardly any growth. A 3.33% return is just not going to cut it (CAGR stands for compounded annual growth rate, essentially the average annual return). You are barely beating inflation at that rate.

Meanwhile, stocks of the supposed "most reliable" large companies of America sorta stunk it up in this particular time period.

But the yellow line, the diversified portfolio (Portfolio 3), wins out on two important fronts: in return and in risk. Look at the data table below - it has the highest return (7%) AND it has a lower standard deviation (9.87%) than US Stocks (standard deviation is the main measure of volatility in investing).

High return at lower risk. THAT's what you're trying to accomplish with proper diversification.

Having a smoother, stable portfolio allows you to engage in long-term financial planning with a larger level of predictability. You can set an expected return for what you think your portfolio will bring - and even though certain asset classes in your portfolio may be more volatile from year to year, the portfolio as a whole will be much more stable because it is an average of its individual parts.

DIVERSIFICATION ALSO REDUCES DOWNSIDE!

Check out something else - look in the "Worst Year" and "Max Drawdown" columns above. These describe the largest drop experienced in any given calendar year, as well as the worst cumulative drop before things went up again. Large US stocks (Portfolio 1) lost half their value at one point (-50.97%), while the diversified portfolio didn't come drop nearly as much (-34.83%). 

Just how important is that difference? Note that if you lose 50% of your portfolio value, you need to get a 100% gain to get back to ground zero. Think about it: if you have $100 and it drops to $50, you need a 100% gain (another $50 of growth) just to get back to your original $100.

On the other hand, a portfolio that drops 35% only needs a 54% gain to recover its value.

Take heed that long-term wealth is about avoiding large drops just as much (if not more) than it is about getting large gains!

True diversification involves investing in several different asset classes that have different correlations with each other.

HOW TO BUILD A DIVERSIFIED PORTFOLIO

Though diversification is a universal principle, there is no perfect, one-size fits all investment portfolio. It all depends on what your financial goals are and how much you can invest over time. Those factors determine what kind of return you need to earn, and then you can go about building a portfolio that will give you an adequate expected return but with the lowest amount of risk possible through diversification.

That being said, next week's blog post will take the next step in explaining how you can invest in entire asset classes all at once (hint: it starts with "mutual" and ends with "funds").

Take care and stay diversified!

I'll Teach You What You Need to Know.

Get blog posts, money tips, and help understanding financial advice from Wealth Mode, the financial planner for people in their 20's and 30's. (Yes, it's free).

Marketing by

None of the above information is to be construed as financial or investment advice. Examples shown are to explain basic concepts and past performance is never a guarantee of future returns. Consult your financial or investment advisor for personalized investing decisions.