- One of the most common perceptions about investing is that it is risky. That is a statement that is easy to make but hard to defend when
you get into the details. To decide whether or
not investing is risky we first need to think about what risk is. Depending on what you are investing in and what you are investing for, there are different ways to
think about and measure risk. In broad terms, risk in investing comes down to the risk of future consumption. Will investing today meet your
consumption needs tomorrow or in 30 years? More specifically, the most important risks that every investor needs to understand are total loss, volatility,
uncompensated risk, skewness and inflation. I'm Ben Felix, portfolio
manager at PWL Capital. In this episode of Common Sense Investing, I'm going to tell you which risks matter when it comes to your portfolio. (techno music) It is common to think about
risk in terms of total loss. You invest your money in a stock, things turn sour, and it's gone. This can happen when you
invest in a single stock, but when you really
diversify your investments, it is much less likely. For an entire stock market, and the index tracking it
to deliver a total loss, we would be talking about a
true economic catastrophe. Even if this did happen in one country, it is unlikely that it would also happen in all of the other countries with functioning public stock markets. For a properly diversified investor, the risk of a total loss is very low. At least as long as capitalism
continues to function. Even for a well-diversified investor, volatility is not a
risk that will go away. When most professionals and
financial product manufacturers are talking about risk, they're talking about volatility. Volatility is a measure of
the variability in returns. A highly volatile
investment would be expected to have big ups and big downs. Volatility is scary for humans. Watching your investments
skyrocket and then plummet is stressful for a lot of people. But is volatility a risk? Well, it depends. If you were investing money
that you need tomorrow, then volatility can
materialize as a real risk. In a 2018 essay in a
financial analyst journal, titled "Volatility Lessons", Eugene Fama and Ken French
constructed a statistical model to examine the probability
of negative risk premiums over various time periods. For the equity premium,
that is the return of stocks in excess of the return
on risk-free investments, they found that over a one-year period there might be a 36% chance
of stocks making you worse off than investing in risk-free
investments like treasury bills. This figure is roughly in line with historical one-year periods across global stock markets. The real kicker in terms of
volatility being a real risk for a short-term investor is that in some cases
those single year losses can be substantial. If you're investing money that
you need in the short term, I would say within five years, then he is an extremely important measure for assessing the
riskiness of an investment. For example, an investment in
stocks would be far too risky due to its volatility for money that you will need to use within the next five years. Even an investment in
bonds could be too volatile for a very short-term need. Whether or not volatility
is a real risk for you depends on two things. Your time horizon and your psychological
tolerance for volatility. If you have a long time
horizon and a strong stomach, then volatility is less relevant. But it still can't be ignored. Even over longer periods of
time, Fama and French found that it should be possible. for stocks to underperform
risk-free assets Over 100,000 simulated 30 year periods, they found that there
was still a 4.08% chance of a negative equity premium. This is one of the most
interesting insights from their essay because there are very few
30-year historical periods that we have to observe in
the real historical data. One important note about
Fama and French's method is that it ignores any auto
correlation in stock returns. Historically, periods of
negative stock returns have generally been followed by periods of positive stock returns. Whether or not we should rely
on this type of mean reversion in estimating future outcomes
is an academic debate. For our purposes, I think
that it is safe to say that due to volatility, it
is possible though unlikely for stocks to deliver a
negative return premium even over very long periods of time. In general, a more volatile investment will have a higher expected return. This means that for a long-term investor with the emotional fortitude
to ride out volatile markets, a more volatile investment, like stocks, might deliver a better expected outcome than a less volatile
investment, like bonds. An important nuance here
is that volatility alone does not indicate higher expected returns. It depends on what is
driving the volatility. There are two main types of risks that affect the volatility of an asset. They are compensated risk
and uncompensated risk. Compensated risk is a systemic risk that the market prices into securities. Stock prices are theoretically the discounted value of future earnings. Taking on compensated risk is sensible. You are buying future
earnings at a discount. The discount is where the
compensation comes from. More compensated risk means a deeper discount on future earnings which means a higher expected return. Uncompensated risk is a very different. It is the risk specific
to an individual company, sector or country. Maybe the visionary CEO ate some bad tuna and started making questionable decisions. A sector is disrupted or a country is affected
by climate change. A good example is the
change in sector composition from 1900 to today in
the U.S. and UK markets. Maybe a big bet on tech today is like a big bet on railroads in 1900. This random risk can
materialize at any time. When you're properly diversified, this type of risk can be
almost completely eliminated. Any time that you own an individual stock or bet on a sector, the uncompensated risk is always looming. You might still benefit
from compensated risk, while owning an individual stock or sector but the uncompensated risk
specific to that asset could easily and unexpectedly dominate your ultimate outcome. All right, so far we
have covered total loss and volatility as risks. In the short term, volatility
is a very real risk. In the long run, it is less of a concern, but can't be entirely ignored. We've also broken down
the drivers of volatility into compensated and uncompensated risk. Owning a single volatile
tech stock does not mean that you have a high expected return, because the volatility
is likely being dominated by asset specific risk, which is not compensated. On the other hand, owning a diversion justified
portfolio of stocks effectively eliminates the specific risk of any one company or sector leaving you with a compensated
risk of the market. Concentration in a small handful of stocks is risky for more than one reason. There is a statistical
measure called skewness that looks at how outcomes are distributed relative to a normal distribution. A normal distribution would
see similar amounts of outcomes with similar magnitudes on
both sides of the distribution. A skewed distribution, positively skewed, in the case of stock returns means that there are
more negative outcomes and fewer positive outcomes, but the extreme positive outcomes are much greater in magnitude
than the negative outcomes. Another way to think
about the positive skew is a distribution with a long right tail. As it turns out the positive skew in stock returns is substantial. In the 2019 study, "Do Global Stocks Outperform
U.S. Treasury Bills?" the authors looked at
61,100 global common stocks during the period at 1990 through 2018 and found that the wealth created in excess of treasury bills by the stock market over that period was driven by 1.3% of
the stocks in the sample. The majority of the firms
in the sample, 61% of them, destroyed wealth over
the second well period. This should be staggering to hear. Investing in most companies resulted in negative longterm wealth creation. And even within the sample of companies that
generated positive wealth, it was only 1.3% of them
that were responsible for the market's overall
positive wealth creation. Even in a portfolio of stocks
that is diversified enough to reduce company specific risk, the strong positive skew in the distribution of stock returns makes any reduction in diversification, relative to the total
market a meaningful risk. The simple the solution
to mitigating the risks of total loss, uncompensated risk and the positive skew in stock
returns is diversification. Which can be achieved cheaply and effectively with a total
stock market index fund. We have seen that
volatility is less of a risk as we move out into longer time horizons, as long as you can handle
the emotional aspect of ups and downs. For the more risk averse investor, or the investor with a
shorter time horizon, adding in some bonds to a
portfolio might make sense. This takes us to the last and arguably the most important risk. Inflation. Investing is done primarily
to facilitate consumption in the future. To do this successfully, the investor needs to generate
positive real returns. That's after inflation. For a long-term investor,
one of the biggest risks is that a safe feeling portfolio, that is a portfolio of
heavily weighted toward bonds, may be exposed to
substantial inflation risk. In other words, after inflation, bonds may not provide sufficient returns to meet your financial goals. From 1900 through 2018, global bonds delivered real
geometric returns of 1.9%, while global stocks delivered
real geometric returns of 5%. A 3% annualized difference
over 119 years is substantial. The lower real returns of bonds call into question their true
safety over the very longterm. To the extent that the higher volatility
of stocks is manageable from a psychological perspective, there is a strong argument that bonds are riskier than
stocks for a long-term investor. There is risk everywhere, and it takes many forms, as investors hoping to meet
our future consumption needs. We are faced with the risk of total loss, the uncompensated risk
of individual companies, sectors and countries, and the substantial positive
skew in stock returns. All of these risks can be addressed easily with a globally diversified portfolio of low cost index funds. Volatility is a risk for
a short term investor or an emotional investor, but over the very long-term, volatility poses less of a
risk to future consumption. Volatility reduction can be achieved by adding bonds to a portfolio, but their lower real returns
call into question their safety in terms of future consumption
as a long-term holding. Thanks for watching, My name is Ben Felix of PWL Capital and this is Common Sense Investing. If you enjoyed this video, please share it with someone who you think could benefit
from the information. Don't forget, if you've run out of Common
Sense Investing videos to watch, you can tune into weekly episodes of the rational Reminder Podcast wherever you get your podcasts. (upbeat music)
