July 21, 2020Individual Investment Management

Why Investing Reduces Risk
Don't trade one risk for another!
 

When I say the word "risk," what comes to mind?  If I asked most people how to define it, they would answer in one or a combination of the following:

  • What is my chance of loss?
  • How variable is the price of this investment?
  • How long is my money tied up?

The funny thing is that each of these are, technically, correct.  An analyst would measure risk almost solely by how variable a given investment is over time.  But when making personal financial decisions (which is what matters to YOU), you must think like a financial planner in your approach.  The financial planner thinks about risk with a simple question:  "How likely will this investment get me where I need to go?" 

For the vast majority of us, our job as investors is to achieve goals - nothing more, nothing less.  We are sacrificing something today to have something tomorrow - there is nothing else that matters other than that objective.  Let's consider the following two assets when thinking about "risk."  We assume a $10k investment left to grow between 1985-current.  We reinvest all dividends, and no extra deposits.  

Asset #1 at left, Asset #2 at right.  Which is riskier??

 

Asset #1 never lost more than 7% in a single year, grew at 6.7% annualized, and resulted in a $99k balance after 1985-2020.*  Asset #2 was much more variable, falling over 35% twice during this time.  However, by 2020 it produced a final balance of over $400k (4x the result of Asset #1) with a return of 10.9% annualized.*   But the most important question is....which asset truly contains more risk??  (And yes....these are real investments you can buy in the market today and their actual back tested performance - I'll reveal them below!)  

Let's assume this money is earmarked for your later years - this is not an unreasonable assumption.  Whatever your "retirement" plans, we all must plan for a day where the possibility exists that we are too old, too sick, too tired, too bored, pulled in a different direction, or too anything to continue to work in a traditional sense.  It is not only sound decision-making on our part, it is also part of our responsibility to our family and our community so that we are not required to live off other people when the time comes.  (Insurance professionals call this "longevity risk" - the risk of outliving your money.)  Asset #2 had the real possibility of solving for this risk despite the fact it was more "risky" by the traditional definition of variability.  Asset #1?  It never had a chance at accomplishing this.  

The moral of the story....

The biggest risk when planning a financial path is that you may not choose investments or vehicles with a real chance at getting you anywhere - all in the name of reducing volatility.  "Risk" takes many forms - but the biggest risk of all is not meeting your goals or choosing investments that trade one risk (volatility) for a more dangerous risk that you don't see coming. Proper investing, where goals are matched with appropriate strategies, is a risk-reducing activity.  

Stay the course and keep investing!

Curious about the investments?
Asset #1 = Fidelity Investment Grade Bond Fund, 1985-2020 (FBNDX)
Asset #2 = Vanguard S&P 500 Index Fund, 1985-2020 (VFINX)

*Source:  Back tested data, Morningstar.com