Don’t Feed the Alligators

A Personal Finance Blog from a Small-Scale Landlord’s Perspective

Creative Commons License photo figure credit: Akuppa

With the recent market turmoil, there has been a lot of talk in the press and even around the water cooler about the nature of risk.  Most people seem to understand that investing in the stock market is risky.  They also understand that the more risk one takes, the greater the possible upside and downside of the investment.  What many don’t seem to understand is what, exactly, is risky about investing in the stock market as well as how risks can be mitigated.

A great book on this subject is A Random Walk Down Wall Street by Burton G. Malkiel.  This book details, for example, why a well diversified stock portfolio is less risky than a single stock.  Malkiel shows that it takes a minimum of 20 to 30 stocks across a number of asset classes to provide sufficient diversification for a typical investor.  For example, if one holds the 30 companies in the Dow Jones Industrial Average, a typical market cycle might have Coca-Cola announce a new product offering which boosts its stock price, while 3M announces layoffs.  These types of stock movements are offsetting and are generally the reason why a diversified portfolio is less risky than individual stocks.

A diversified portfolio is still exposed to “systemic” effects on the market — effects that are spread across the whole market.  This is most easily observed in the current market turmoil.  Clearly it’s not possible for every company to be doing poorly right now — somebody must be making money in a Bear market.  But the market average is down, and as a result, many good companies are getting hit hard on their stock prices simply because of the financial crisis.

Another aspect to risk, and the one about which I have been trying to remind my coworkers and friends, is the time factor.  When purchasing an investment, one has to be aware of both the time one can afford to tie up money in the investment, as well as the typical time for the investment to achieve the kind of return being sought.  This is fairly easy to see with a Certificate of Deposit: you buy a CD that pays a certain percentage yield and that has a limited lifetime of months or years.  There are penalties for withdrawing money early.  The equation is less well defined when it comes to investments such as houses, stocks, or tulips.  The risk with investments such as these (well, not the tulips as much…) is not that the investment won’t hold value or yield a return, but rather over what time period the investment will pay off.

Conventional wisdom suggests investors be prepared for minimum investment times to substantially reduce the chance that the investment will depreciate while held.  The purchaser of a house, for example, should be prepared to hold the house for 5 years or longer to have a high degree of certainty that the money invested can be recovered in full.  Diversified stock portfolios are more like 10 years of holding time.  In fact, (according to Malkiel) there has never been a 10 year period since 1926 in which the stock market has returned a negative yield, and there has never been a 25 year period in which the return was less than 8%.

The point in all of this is that you should not panic about the volatility of the current market.  In fact, the less you pay attention to it the better off I expect that you’ll be.  If you are investing for retirement and you have ten years or more left to invest, you shouldn’t even sweat during this crisis.  If you have less than 20 years until retirement, or are retired already, you should have made and be making annual or semi-annual changes to your portfolio to reduce your risk exposure by locking up your stock gains in less risky vehicles like bonds.  This is what’s known as rebalancing your portfolio.  If your time horizon for a certain pile of money is shorter than 10 years, then your exposure to the stock market should be minimal.

The absolute worst thing that you can do right about now is to get scared and change the way you are investing because of the market fluctuations.  Selling off stock now is the opposite of what everyone knows is the key to investment success: buy low, sell high.  Selling now is “selling low” and locks in your losses.  I have not lost any money in the current market, and I say this because all my losses are on paper so far.  I still own the same number of shares this week as I did last week.  Only by selling shares now can I be sure to lose money in this market.  History tells us that some of the greatest days in the stock market follow some of the worst, and Monday’s stock market performance is certainly evidence of this.  Selling when the market is low takes your money out of play and eliminates any chance of regaining the value lost in your portfolio as the market rebounds.

Are you concerned about the loss of value in your 401k plan?  Have you made any changes to stem your losses, or are you just gritting your teeth and bearing it?  Do you find yourself checking the value more frequently or less frequently because of the volatility?  How much risk can you stomach? I’d like to read your perspective on the situation in the Comments Section below.

3 Responses to “Understanding Risk”

  1. Investment Blog Directory Says:

    Risk is paramount in this environment and really at any time. Clearly there was (and still are) a large number of investors who didn’t understand the risks they were exposed to in their investments. Whether that be real estate, stocks or alternative investments investors always need to be aware of risk.

    Great blog btw - let me know if you’d like to be included in our directory

  2. MITBeta Says:

    Right. Much of the risk of the investments that have gone bad were concealed from the investors. A more transparent approach would have allowed the “free” market to properly assess the value of those investments initially, rather than having the bottom fall out months or years after the fact.

    But the major point that I was trying to make in this post is that most people have not actually lost any money, since it’s all on paper (unless they cash out, in which case they lock-in their losses). If they are invested for the long term, the risk is very low — even if they are invested in “high risk” investments like stocks and stock mutual funds. Few people understand that time is major factor in assessing the risk of an investment. It’s unlikely that any investment will go to zero, but the question is whether or not there is enough time to recover any paper losses before the investment needs to be available to be used.

    Thanks for stopping by, and I’ll check out your directory.

  3. Tak Says:

    my God, i thought you were going to chip in with some decisive insght at the end there, not leave it with