Is equity all that risky?

Jul 08, 2015
With a very long time horizon, stocks actually may be the least-risky asset of all.

Last week, in Make your portfolio safer with risky investments, we wrote about shortfall risk and why investors must invest in equity if they need to meet their long-term goals. We continue in the similar vein.

David Blanchett, head of retirement research for Morningstar Investment Management, conducted in-depth research on the volatility of equity as an asset class. He looked back on historical returns in 20 different stock markets across the world and at time periods from 1 to 20 years.

His research contradicted the thesis that stocks are the high-risk portion of investors’ portfolios. In fact, with a very long time horizon, stocks actually may be the least-risky asset of all. Equity, over the long term, actually gives the benefit of increased returns without upping the risk taken.

For instance, the Sensex in 2008 had a 1-year return of -52.45%. An investor who would have invested a year ago (at the peak of the bull run) would have seen his investment slaughtered. Had that very same investor invested in the Sensex 5 years prior, his return on December 31, 2008 would have been 9.43%, despite the market going into a free fall. Had he invested in the Sensex for 10 years, his return on December 31, 2008 would have been 14.47% compounded annually.

A summary of Blanchett's views have been reproduced below, to see the video, click here.

Observation I: For individuals with a long-time horizon, stocks may be the least-risky asset of all.

People think about stocks as being volatile investments, because they are. What we found was that the longer you hold stocks, the safer they become. People think of cash as being a safer investment for longer time periods; stocks actually were a safer investment for someone investing for maybe 10 or 20 years versus cash or bonds.

So if you're someone with a very long time horizon, stocks actually may be the least-risky asset of all, even though it appears kind of counterintuitive.

(Shannon Zimmerman, associate director of fund analysis, explains this viewpoint of stocks being safer despite volatile. For the most part, the main risk individuals are concerned with is the risk of permanent capital loss. You are putting your money to work in a vehicle that you hope will generate positive returns and you can rely on in retirement or for big-ticket purchases--the risk that that that might not happen, in fact, you might even lose money--that's the risk that individuals want to protect against the most. So, volatility may be viewed as a kind of risk, but the main risk that investors want to protect against is the risk of permanent capital loss.)

Observation II: Investors with a sufficiently long time horizon and a pretty high short-term risk tolerance could be all equity and generate a better return than a blended portfolio.

This really speaks to the idea that the more time you have to invest, the more aggressive you can be. But an important part of that is how comfortable you are holding that portfolio for a long time horizon.

Back in 2008, if you were going to panic and sell out of stocks, then an aggressive portfolio isn't for you. But if you're an investor who really can stomach these ups and downs, this evidence suggests strongly that holding stocks is a great long-term investment philosophy.

Observation III: The behavioral piece is the key.

If you're someone who thinks you might capitulate at the bottom, then an equity-heavy portfolio won't make sense for you. Look back to how you reacted in 2008, if you had this long-term plan, and you were OK with the market going down 40% and holding on, that's a good investor for the long haul for stocks. Someone who panicked and sold out in 2009 would not be a good investor for this kind of aggressive portfolio stance.

Observation IV: People in drawdown mode absolutely need to have some investments set aside that they can use for liquidity purposes.

Throughout someone's lifecycle, stocks can really work. Even for some investors who are older, in retirement for example, and have a lot of guaranteed pension income. If you take that 20-year plus picture of retirement, equities may seem a bit safer all things considered.

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