I keep a book on my desk at our office called “The Black Swan – The Impact of the Highly Improbable” by Nassim Talib. A Black Swan is defined as an unpredictable or unforeseen event, typically one with extreme consequences. I keep it there to remind myself that the future is uncertain regardless of how much research I read, my educational background, or my professional designations.
An investor’s ability to remain humble is one of the first steps in making a good investor. The investment writer William Bernstein recently said, “The only Black Swans are the history you haven’t read.”
We have had pandemics in the past, from the 1918 Spanish Flu, Swine Flu, Ebola etc. We have never shut down the global economy until COVID-19. The fact is, there will always be unknown risk that must be managed.
In my opinion, one of the biggest misconceptions about managing risk when investing, means you need to figure out what’s going to happen in the future. I would argue that managing risk involves planning for a wide range of outcomes and building portfolios that will do well in a wide variety of environments.
The definition of risk is debatable among investors, it could be defined as volatility in stocks, missing big gains, taking big losses, interest rate risk, default risk, and so on.
However you choose to define risk, it cannot be eliminated, it can only be transferred and managed.
If you are 100% invested in cash, you have the lowest expected return. You will unlikely see the volatility we have seen in stocks with the associated decline in value. You have removed the risk of volatility, but now you have the risk of loss of purchasing power due to inflation. You avoided volatility, but if you remain invested in cash you are potentially losing money in the long term, based on historically returns of stocks, bonds and cash.
Currently, investing 100% in bonds, offers the lowest interest rates in decades. The correlation between starting yields and future long-term returns is high, meaning you can use these rates as approximation of future bond returns. The volatility in bonds has been less than stocks, but now you have introduced interest rate risk and default risk among other risks. As interest rates rise, bond prices fall. You may see less volatility, but you are accepting lower returns into the future.
If you are 100% invested in stocks you have the highest expected return and also the highest potential decline in your account.
From 1928-2019 the returns for stocks, bonds and cash are as follows:
- Stocks +9.7%
- Bonds +4.9%
- Cash +3.4%
A $100 investment over this period of time, would have grown as indicated:
- Stocks $502,417.21
- Bonds $8,012.89
- Cash $2,079.94
*Past performance is no guarantee of future performance.
It is easy to look at this data on a spreadsheet and say put all your money in stocks and talk to me in a few decades. We don’t live on a spreadsheet, we live in the real world where people have income needs, emotions, and different goals other than to make the most money possible over decades. Those goals range from a house renovation, to helping pay for grandkid’s college, and most importantly, to make sure you don’t outlive your account.
Our Global Balanced Advisor, Growth Equity Portfolio, and Diversified ETF Portfolio have a stock bias because we know, over time, we should have as much as we prudently can in stocks, knowing that there will be declining market periods, but the long-term direction historically is up. Again, it doesn’t mean investing 100% in stocks, especially if you have a short-term cash requirement or cannot handle the volatility, we would have more in bonds and cash.
Ultimately, the biggest risk is not having a plan. We want to have a plan for you based on your needs and goals. We want to have a plan for a wide variety of outcomes in the market. We want to have a plan that is not based on emotion or rash decisions. Mike Tyson, the professional boxer, once said, “Everyone has a plan until they get punched in the mouth.” I think it’s safe to say what we experienced in the market and the economy in the past few months has felt like a punch in the mouth. We had a plan in place to weather this storm. It turned out this time to be a global pandemic, whatever it may be next time, I can tell you, we are making sure we prepare ourselves and our clients for a wide range of outcomes and building portfolios with that in mind.
We wish you all a Happy Memorial Day. Thank you to those who have served our country. We truly appreciate your service.
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Regis R. Dillon, CFA, CFP®
Chief Investment Officer