Are Stocks Actually Risky?

Summary/TL;DR

Research provides no validation for the general classification of stocks as “risky”. Risk is multifaceted and has more to do with one’s time horizon than anything else when it comes to investing. One primary characteristic of stocks (globally diversified indexes of stocks, specifically) is that they become less risky over time, contrasted with bonds, which become riskier with time.

Introduction

Stocks have a reputation for being “risky” while bonds are generally thought of as “safe”. This unfortunately common paradigm has led to many investors, retirees specifically, being far too conservative with their investment portfolio. Ironically, this results in them taking on more risk than is warranted.

What, then, is the true track record of stocks and bonds and their relative degrees of “risk”?

What Do We Mean By Risk?

The first thing that needs to be clarified in this discussion is what is meant by risk. Risk is often thought of as taboo behavior, or just something that you “don’t do”. It’s commonly assumed to be something that’s inherent within certain things, no matter what the broader context of circumstances might be. “Owning a high stock portfolio in retirement is risky”, or “stocks are risky”, are examples phrases that have been engraved into just about every retiree’s mind that embody this notion of risk.

This is completely wrong, however. Risk is not something that is inherent in anything! Risk is multifaceted - it’s a function with many different variables and inputs. Defining something as risky is to say that it increases the likelihood of an unfavorable outcome. When it comes to portfolio management in retirement, there is no more unfavorable outcome than a permanent decrease in the inflation-adjusted value of a portfolio over time. Within this context, therefore, risk is properly defined as anything that increases the likelihood of reducing the inflation-adjusted value of your portfolio throughout your retirement.

Owning a high stock portfolio in retirement might be risky for you. It could also be far safer than owning a low stock portfolio. There is simply no way of knowing until your unique circumstances are considered within the context of historical facts and research. Only then can it be determined how a change in your asset allocation will affect your risk.

Stocks For the Long Run

Fortunately, a lot of research has been done on this subject. In his book, Stocks for the Long Run, renowned economist Jeremy Siegel examines the long-term performance history of major asset classes, namely stocks and bonds.

Long term stock returns have clearly blown bond returns out of the water, producing an annualized after-inflation rate of return of about 7%, compared to only 3.6% for bonds (with dividends and interest reinvested). Clearly, however, it was a bumpy ride along the way. Stocks are notorious for their short-term volatility, and when this is combined with regular distributions throughout retirement, a risk of permanent long-term losses can arise. This begs the question – “at what point, or over what time horizon, does it make sense to own stocks instead of bonds?” Fortunately, Siegel addresses this question as well in the following chart.

Notice how the relative returns for stocks and bonds change as the holding period increases. After 10 years, stocks not only have a range of returns possessing a “higher high” than bonds, but also a “higher low”. In other words, you were more likely to lose money in bonds than you were in stocks over any given 10-year period.

This characteristic of stocks, in which risk is reduced through longer holding periods, is a feature of mean reversion. This simply means that stock returns become more predictable the longer that they are held. Bonds behave in the opposite fashion, with their returns becoming less predictable the longer they are held. And historically speaking, the inflection point at which stocks become less risky than bonds is between 5-10 years.

Consequently, it is actually safer to invest in stocks for any holding period that exceeds 5-10 years relative to bonds (which is most of one’s life, including retirement). Being too conservative, or not having enough stock in your portfolio relative to bonds, therefore increases your risk in retirement.

What Do We Mean By Stocks?

Throughout this post, I’ve been using the term “stocks” to mean a globally diversified mix of publicly traded companies. I am not referring to strategies that involve stock picking, market timing, or anything else that doesn’t involve purchasing a broad basket mix of stocks and holding it for the long run.

By far the easiest and least expensive way to accomplish this is through the purchase of index funds. An index is simply a basket of assets, the collective value of which gets boiled down to a single number. An index fund, therefore, is a fund, available for purchase, that tracks one of the thousands of indexes that track stocks, bonds, and various other asset classes in this way.

There are three main characteristics of index funds that make them the most reliable way to capture the consistent long-term rate of return that stocks have to offer. First, they the safest way to invest in stocks. The most popular index funds contain hundreds, and sometimes thousands of companies. Therefore, in order for you to “lose everything in the stock market”, every company within the index would have to go bankrupt – a scenario in which we can imagine the stock market being the least of our worries. Second, indexes make all of the important decisions for you. The most popular type of indexes are market capitalization weighted, meaning that the larger a company is, the more representation it will have in the index. This generally results in the most profitable, well run, and most innovative companies making up more of the index (and therefore more of your portfolio). And the moment that a company stops meeting the strict requirements set by the index, it is replaced by a company that does. Finally, and perhaps most importantly, passively holding index funds has a long track record of outperforming active investment strategies such as stock picking, market timing, etc.