Friday, April 29, 2016

Are You Certain You Understand Stock Market Risk?

Many investors will tell you the reason they are not currently invested in the stock market is because it's too risky. If you press, they'll describe their fear that, at any time, the market could drop and they'll lose their money.

Sadly, most look no further. Instead they'll leave their money in a savings account earning nothing, which is equivalent to losing 3% or so a year due to inflation. Or they'll put in a coffee can. Or worse, they'll spend it on a depreciating asset, like a car or a living room set.

Most people misunderstand stock market risk. They confuse the risk of owning stock in a particular business with the risk of owning a diversified basket of market stocks— or a broad-market exchange-traded fund. They rightly fear that, without proper education or a willingness to get deep into the weeds of investing, their hard-earned dollars will disappear, even if they do everything "correctly," due to bad luck. So they do nothing.

I can't blame them. There is no formal education in American high schools, and precious little in college, to familiarize them with basic investing concepts such as the power of compounded interest, managing risk and expectations, or opportunity cost. They are left to sift through the gazillion messages thrust upon them from financial TV, newspapers, social media, billboard advertising, and the painful personal anecdotes of their friends and colleagues. The takeaway is that investing is difficult, complicated, frustrating, hazardous.

In fact, it is doesn't have to be any of those things, at least not permanently. Yes, the market swings wildly day to day (and some individual stocks will make you absolutely sick: have a look at Monster, and Netflix). Some years, like 2015, the broader market goes nowhere. And some years, like 2008, it drops precipitously. If you're in the stock market, you will lose money again and again, on paper. It is unavoidable. But smart investors know that over time, the market rises. Absolutely always, no matter what. However bad it looks up close, step back a couple of years and things smooth out. Hold that in your head, endure the short-term drops and stay with it, and you'll find that investing can be actually quite simple and extremely profitable.

Of course, it is in the interests of Wall Street brokers and financial managers everywhere to hide that information, so they will be paid to sort, advise, and manage your money. I expect that the democratization of information will ultimately come to finance, as it has to automobile sales, taxi service, travel booking, and other industries. But until then most folks will be left in the dark. So let's be very clear.

Owning a few shares, or a few hundred shares, of any one business is risky. There are no two ways about it: an individual shareholder has effectively zero power to sway the outcome of that investment, so whatever happens to that company will affect the investor. The business could outspend its sales (Twitter). It could be targeted for legal action (Google). Its products or services could change or be upended by those of a competitor (Apple vs Sony). Or it's entire business model could simply cease to be relevant in a fast-changing environment (Radio Shack). Those risks are real and they are substantial. When you buy that stock, you are placing your faith in the management of that company to shepherd their company, and your investment, to ever greater heights. But no one can see the future and things go wrong all the time.

By contrast, however, owning a few shares each of 10 or 20 businesses is less risky. Things that go wrong at one business are unlikely to affect the other businesses whose stock you hold. One company could hire a new CEO with completely the wrong ideas for the future, and that company could tank. But your other businesses will be fine, so the overall financial risk of ownership is reduced. (Assuming, of course, that the companies are not all in the same  or related industries.)

And by the same token, owning shares of 500 businesses, as one would when buying shares in a low-cost S&P 500 index fund like the Vanguard 500 ETF (which I've discussed before, in this post), is nearly risk-free.

WHAT!? Of course it's not risk-free! you shout. What if the market falls, like in 2008? Or 2000? Or for that matter, like in 1929?

In previous blog posts I've talked about only investing money you don't need for a minimum of 5 years, but preferably for 10 years or longer. We're talking about your toddler's college fund, or your retirement. This is a long, long game. And here's the thing: over time, the S&P 500 always goes up. If you buy an S&P 500 ETF and it goes down, just wait. It will come back up and go on to huge gains. It simply will: I know this because it's been rising in the long term since George Washington won the presidential election in 1789 (unanimous, by the way).

But that's the difference between real stock risk— that any one company's shares will fall and not come back— and perceived market risk. Advisors everywhere describe the stock market as dangerous to asset preservation. They tell their clients not to have too much in the market. They urge diversification. Ok, that's smart. But nowhere else can a typical disinterested and passive investor earn a long-term average return of 10% per year (over the past 100 years) for doing nothing. Because the broader market never stays down. If you own a big basket of stocks, or a broad indexed ETF and things go down, just don't sell. It's long money. Reign in your fear. Stay the course. The market will come back up.

Understand what is, and what is not a risk. Buy that ETF and sit tight. Couldn't be easier.