In the investment world risk is most often defined in statistical terms as something called “standard deviation”. In laymen’s terms we call this volatility; the measurement of the ups and downs of the market, an entire portfolio, or an individual investment such as a mutual fund or stock.
Most often standard deviation is measured as volatility experienced over a one year time frame.
For the average person saving for retirement, or already retired, this standard deviation measure of risk over one year has little, if anything, to do with their financial goals. That is why we look at risk a bit differently.
We think of risk in terms of the odds that someone will not achieve the lifestyle they desire over their lifetime.
There are numerous factors that go into achieving a specific amount of retirement spending, and most of them have nothing to do with what the market did yesterday, last week, last month, or last year. (The grey bars in the graph above reflect the returns that sector of the market delivered in March 2015. The brighter orange bars reflect the annualized annual returns that sector of the market delivered over the past ten years.)
Nor does the market’s performance tomorrow, next week, next month or next year matter a whole lot.
What matters a bit more is what the market does over the next decade. The challenge we have is that without a copy of 2025’s newspaper, we don’t know exactly what the next decade will look like.
In light of that reality, what we focus on is what we do know.
- We do know that how much you save and how you manage your expenditures has a big impact on your success.
- We do know that those who consistently monitor and review their financial plans make more progress than those who don’t.
- We do know that managing taxes increases the after-tax cash flow available to you. Managing taxes includes advising on what types of accounts to fund (Traditional IRA or Roth IRA for example) as well as what accounts to withdraw from, and how to rebalance your portfolio without causing you a hefty tax bill.
- We do know that there are numerous ways to construct a portfolio and that there is no free lunch.
If you are going for maximum returns you are increasing the risk that you will not achieve your goals.
If you are going for an approach that brings additional security to the outcome than in strong markets you will be leaving some returns on the table. That is just the way it works.
Or as one famed finance professor puts it, “There aren’t $100 bills lying around for the taking.”
The problem is a lot of finance shows, magazines, and news articles lead you to believe that there are $100 bills lying around for the taking – and that the “right” trading strategy is what it takes to find them.
Every week we are asked questions about other approaches such as, “I read I shouldn’t own bonds; shouldn’t we sell our bonds?” Or, “I read the stock market is overvalued; shouldn’t we get out of stocks?”
We can assure you the advice you read in a magazine, see on TV, or hear on the radio was not constructed around the risk/return framework that applies to your life. It can’t be—these finance buffs don’t know your financial situation. It doesn’t mean what they say isn’t valid—it simply means most often, it doesn’t apply to you. I expand upon this concept in my MarketWatch article Why One Size Fits All Investing Never Works.
What makes sense is to build a plan based on your financial circumstances. This is what we do. Once we know your goals we choose to use an approach that we believe gives you the highest probability of achieving those goals over your lifetime. It’s not based on some arbitrary measure of risk that has nothing to do with your life circumstances – it is based on your cash flow, life and family circumstances. That’s the way to look at risk.
*Returns data in graph above from Advisor Intelligence. When possible we report index fund returns to show performance net of fund fees. As such in the graph:
Total Bond Market Index is: Vanguard’s Total Bond Market Index Fund(VBMFX)
US Large Cap is: Vanguard’s 500 Index Fund (VFINX)
US Small Cap is: Vanguard’s Small Cap Index Fund (NAESX)
Real Estate is: Vanguards’s REIT Index (VGSIX)
International Large cap is: Vanguard’s Total International Stocks Index (VGTSX)
International Small Cap is: MSCI World Ex USA Small Cap Index (not a fund)
Emerging Markets is: Vanguard’s Emerging Market’s Index Fund (VEIEX)
(Investment Sense is a monthly posting of market commentary with a common sense twist. For all our latest commentary follow us on Facebook.)