Real Risk vs. Perceived Risk

There are some risks in life that are real. If you live in a hurricane-prone area and don’t have hurricane insurance, you are taking a risk that could lead to a permanent loss. If your home is flattened, it doesn’t grow back if given enough time. That is a real risk – the risk of a permanent loss.  

The financial advising world often talks about investment risk in the context of market fluctuations up and down. We categorize investors as risk-averse if they are unwilling to deal with bouts of volatility. What we are measuring is perceived risk – a temporary decline in the stock market that often feels permanent to the investor. It is much different from the real risk in the example above. While anything in the future is possible, so far in the entire history of the U.S. stock market, permanent loss of capital has never happened (unless you owned individual stocks).

Knowing that the stock market has always bounced back does not help you understand how painful and long a temporary decline can be. During the 2008 financial crisis, investors essentially opened 18 monthly statements in a row, each one lower than the previous one. By the 18th statement, it is nearly impossible to consider the possibility that the 19th will be positive.

It’s also not just money. These are the funds you are saving to provide a living for your family one day in the future. As Morgan Housel puts it in his book The Psychology of Money “To get why investors sell out at the bottom of a bear market you don’t need to study the math of expected returns; you need to think of the agony of looking at your family and wondering if your investments are imperiling their future.” 

However, despite the pain, if given enough time, every decline eventually recovered and then went on to make higher highs. The key words there are “if given enough time.” This brings me to the risk that every advisor should be calculating. And that is risk capacity – the risk an investor can afford to take given their financial goals.

We should expect that in the short term a lot can and will go wrong, and in the long run a lot can and will go right. If you have short-term needs for money over 5-10 years, those funds should be conservatively invested. For money needed in 10+ years, historically it has been safe to allocate to stocks. Good returns on these funds require consistent, uninterrupted investing over a long period of time, especially during moments of panic.  

Happy Planning, 

Alex

This blog post is not advice. Please read disclaimers.