Equity is risky. It’s the nature of the beast.
At least that is the perception of most investors. Which would explain why, when saving for their retirement, they incline towards a portfolio heavily laden with fixed income instruments such as the Public Provident Fund, National Savings Certificate, bonds from financial institutions and fixed deposits.
But to blatantly disregard equity in a portfolio citing risk is a very lopsided argument. What if we turn it around and state that the greatest risk for most investors is not meeting their goals?
Think about it. Any investor who parks too much money in fixed-income assets faces other types of risk such as inflation risk and shortfall risk.
A high rate of inflation would erode the value of your savings. If we look at the CPI over the past decade, inflation has varied from 3.78% to almost 15%. (Source: Inflation.eu – December vs December from 2004 to 2013). Now add the tax factor to this, and the return from your fixed income instrument is suddenly not all that lucrative.
Shortfall risk is the risk that an investment’s actual return will be less than the expected return, or more accurately, the return needed to meet one’s investment goals. Is that not a frightful thought? Retirement investors must come to terms with a fundamental risk—that of not having sufficient growth in their portfolio to sustain income for many years in retirement. While they can gleefully point out that a lower equity exposure in a retirement portfolio has helped protect against short-term market setbacks, what they fail to note is that it provides less retirement income over the long run. Herein lies a grave error. By focusing on short-term losses, investors inappropriately confuse risk with volatility.
The confusion between risk and volatility
To elucidate this point, let me explain how Seth Klarman views risk. This world-renown money manager and author points out how risk and uncertainty differ. He does not believe that risk is inherent in equity, it is relative to the price paid. So in 2008, when great uncertainty prevailed and volatility sent investors scurrying to the exit, prices of stocks fell to such low levels that they actually became less risky investments. The risk of investing in equity dropped in 2008 when compared to the market frenzy of 2007. Ironic is it not it that most investors feel more risk-resilient in a galloping bull run and more risk-averse when the market falls off the cliff, when actual reality is the reverse?
Evidently, this is not just a topic that finance geeks may squabble about, it is crucial for investors to understand the difference between the two to ensure that they reach their financial goals. How do we reconcile the two?
There are two aspects to volatility.
The first is the sudden price movements. It encompasses the changes in the price of a security or a market segment, both on the upside and down. So it’s possible to have an investment with a lot of volatility that is moving one way: up (not always down). The more volatile the security or asset, the more wildly its price tends to bounce up and down.
Even more important, volatility refers to price fluctuations in a security, portfolio, or market segment during a fairly short time period—a day, a few weeks, a month, even a year. Such fluctuations are inevitable and come with the territory.
Over the long term, there is no connection between risk and volatility. In fact, if you are in for the long haul, volatility is not a problem and can even be your friend, enabling you to buy more of a security when it’s at a low ebb.
Recall the down markets of 2008 and 2011? However gut wrenching the volatility was during that time, investors who stayed put and continued investing are today much better off because of it. Take a longer term view. On January 2, 1995, the Sensex closed at 3,932.09. On that very day in 2015, it closed at 27,887.90. And over these past two decades, the Indian stock market has gone through tremendous turmoil - the 1997 Asian financial crisis, the dot com bust, the Ketan Parekh scam, the 2001 India-Pakistan standoff that brought both sides close to war, the 9/11 terrorist attacks on the Twin Towers in New York, the political uncertainty in 2004 which saw the Sensex slip from 5,400 (May 13) to about 4,500 in four days, the global financial crisis in 2008, and the ongoing European debt debacle. Yet the stock market has delivered admirably.
When evaluating the substance of your retirement portfolio, don’t make the mistake of taking your foot off the gas pedal by mindfully winding down your exposure to equity. By focusing on volatility and thereby eliminating equity from your portfolio, you are exacerbating shortfall risk. It’s a misjudgment you could live to regret all your life.
Key takeaways:
- Don’t let extraordinarily poor short-term returns hinder a critical long-term investment decision, such as retirement.
- By eliminating equity from your retirement portfolio, you run the risk of running out of income in retirement.
- The stock market will always go through bear phases, and probably extreme ones at that. Don’t have a myopic view of it.
- Understand that volatility is inevitable, and if you have a long enough time horizon, you'll be able to harness it for your own benefit.
- The best chance of not running out of money in retirement, is to have a sensible and adequate participation in the equity market.
