The financial services industry equates investment risk with volatility. In the last couple of posts, we considered a broader definition of risk: the possibility of outliving one’s money in retirement. Volatility is one aspect, or component, of this broader risk. But a second key component is the possibility of earning investment returns insufficient to keep pace with inflation. As we saw in the March post, the latter inflation risk posed a greater danger to retirees’ portfolios than volatility, at least over the last nine decades.
This month, I’d like to broaden our definition of risk still further, so that it can be applied to all financial goals, and not just retirement.
As an investor, you probably aren’t saving and investing merely for the sake of seeing your account balances grow. Rather, you likely have specific goals in mind. You might be saving for your kids’ college education, for a new house, or for your retirement. Maybe you want to start your own business, and are saving and investing to raise the needed capital. Or maybe you are saving and investing for a dream vacation, a new car, or a boat. Whatever your financial goals and dreams might be, you the run risk of falling short of them. For many investors, the really big risk is this shortfall risk. If you worry that you may not be able to grow your savings to the amounts needed to pay for your goals and dreams, then you, too, are concerned with shortfall risk.
Although we’ve been focused on the risk retirees face of outliving their money in the last couple of posts, this risk is really just one example, or manifestation, of shortfall risk. The main financial goal of most retirees is to avoid running out of money; the key risk they face is the possibility of coming up short of this goal. Shortfall risk thus includes the risk of going broke in retirement. But since shortfall risk also encompasses the possibility of coming up short of any other financial goal you might have, it is much broader than the risk of outliving one’s money. It is also a very practical, utilitarian definition of risk, relating directly as it does to the reasons why we save and invest in the first place. If the whole point of investing is to enable us to afford the things or experiences we want, then what could be a more obvious, useful, and all-encompassing definition of investment risk than the possibility of coming up short of the amount of money we need to buy these things or experiences?
Like the risk of outliving one’s money, shortfall risk comprises two main investment-related components: volatility, and the possibility of earning returns insufficient to beat inflation. Volatility poses the biggest danger to our short-term goals, while insufficient returns most threatens our long-term goals.
There is a crucial difference between these two shortfall risk components. Volatility, unlike insufficient returns, is easy to hedge. You can reduce, or even eliminate, the danger to your short-term goals posed by volatility by relying primarily or exclusively on fixed-income investments to meet these goals. Suppose, for example, that you are the parent of a newborn baby. If you set up a college fund for your newborn, you can at first afford to invest the fund aggressively in stocks and stock funds. Even if your stock investments decline in the first few years, they should have plenty of time to recover. Short-term stock market volatility won’t present much of a risk eighteen years ahead of college. As your kid grows, you can slowly reduce your allocation to stocks, and increase your allocation to fixed-income investments, while all the time adding savings to the college fund. The risk posed by stock market volatility will increase as your child’s eighteenth birthday approaches, but you can control and reduce this risk by continually shifting towards a more conservative asset allocation as the time horizon shortens. Once you’ve reached your savings goal, you can switch to a 100-percent cash allocation. Volatility is a risk, but there is a simple hedge for this risk: bonds and other fixed income investments.
But how do you hedge the risk of earning long-run stock returns that fail to meet your expectations? Even worse, what if long-run stock returns don’t even match inflation? It’s not as if there are other investments out there that generate returns better than stocks. Over the long run, nothing else has even come close to matching the returns on offer from the stock market—not bonds, not gold, not other commodities—nothing. And yet, the stock market goes into long slumps, known as secular bear markets, on a regular basis. The most recent of these secular bear markets encompassed the so-called “lost decade” of 2000-09. From January 2000 through December 2009 the S&P 500’s annualized total returns (including dividends) were negative 1 percent.
Nor is the 2000-9 lost decade some weird anomaly. There have been four secular bear markets since 1900, if we define a secular bear market as a period lasting at least 10 years, and during which annualized large cap (large company) stock returns failed to outpace inflation. In addition to 2000-9, these long periods of anemic stock returns include 1902-20, 1929-41, and 1966-81. Taken together, these four bear markets account for 58 of the last 115 years. In other words, for more than a century we have been in secular bear territory half the time! Clearly the 2000-9 lost decade is not some anomaly that can be easily dismissed as unlikely to recur. On the contrary, if history is any guide we must expect, and prepare for, lengthy periods of stock market underperformance.
How can you do this? As the book I am writing now explains, small caps, value stocks, and small cap value stocks hold the key. But first, it is important to get a better handle on the specific shortfall risk you face, by estimating it. In the next few blog posts, I will explain how you can use free resources available to anyone on the internet to estimate and minimize the odds that you will fall short of your financial goals, whatever those goals may be. Specifically, I will explain how to select the best retirement calculators on the web, and how to use one of those calculators not only to estimate your “retirement number” and your risk of outliving your money in retirement, but how to estimate the amount of money you need to be saving annually to minimize your shortfall risk for any goal you may have—a new house, a dream vacation, a college education for your kids—anything. Using what you will learn in the next few posts, you will be able to create a saving and investment plan that will help ensure that you will reach your goals and dreams—whatever they may be.