Investing. Stocks. Risk. Fear. Return. Volatility. All of these terms go together. The so-called Risk vs Reward spectrum means that investors should rationally demand higher returns for riskier investments as compensation for bearing that risk. So ultra-safe US treasuries or cash accounts will have the lowest returns. Riskier investments like stocks, real estate, longer-term bonds, or various alternative investments should have higher returns (but also an increased chance of losing significant value). But the term risk is thrown about pretty loosely and is viewed differently by many people. So this article will delve into risk. Particularly risk in investing. I’ll use the stock market as an example since it is my primary vehicle for maintaining and growing my own long-term wealth and security. I believe it’s critical to understand this well for your long-term financial success, particularly in early retirement where you are likely to be dependent on investments to sustain your spending for 40-50+ years. As you understand this better, you’ll make better investing and allocation decisions and also be less likely to make poor short-term financial decisions. The vast majority of FIRE success stories involve people who understand this well. It’s worth learning.
First, let’s start by discussing what risks we need to understand. There are many types of risks in investing. There is the most obvious risk of whether your investment will unexpectedly drop in value, and how big such a drop might be. This is clearly what scares so many people about the stock market. Many, many people equate investing in the stock market as no better than going to the local casino with their money. They believe investing is pure chance and is not a prudent thing to do with their hard-earned money. Just like in gambling, you can’t predict whether you will win or lose on the next toss of the dice. However, as I’ll describe below, investing is very different from gambling over long periods of time. Over long periods, you are virtually guaranteed to lose money gambling. In investing, you are virtually guaranteed to make (quite a bit) of money. You are the house in investing and long-term probabilities are greatly in your favor. Ironically, many of the people who view investing as gambling don’t feel it’s risky to spend most of their income and end up with little savings. These people are unlikely to retire early or maybe even at all. If this is you, then you have a burning financial emergency on your hands and you need to educate yourself quickly about the basics of sound personal finance.
For most others, they fall somewhere in the middle. They know the statistics about long-term stock market returns being around 10% (which is absolutely incredible to me). At the same time, they know very well that stocks often drop, and drop by a lot. Many have clear memories of the dot.com crash and the financial crisis of 2008. For the financial crisis, it’s hard to overstate the fear that existed at the time. It seemed a real possibility that the entire global financial system could collapse and many people for the first time started to understand that much of the value in financial instruments is just based on people’s perception of what something is worth. Scary stuff. Many people sold their stocks during that time, unable to handle the decline and the negative projections for the future. Many also swore off stocks at that time as well and missed out on the subsequent recovery. And now stocks seem expensive so it seems too late to invest. Many are still torn and on-the-fence about stocks. There is a lot of angst out there and still a lot of cash on the sidelines.
Financial Professionals and their conflict between keeping clients happy and helping them gain wealth.
Fear is an amazingly strong emotion in our lives, much more than most realize. Professional financial planners realize this and so a lot of effort is spent in understanding the psychology around investing fear in their clients. If they make recommendations that make their clients overly fearful, then when things go south (which they will), their business is at risk. So financial planners spend a lot of time building a plan that their clients are comfortable with (and is usually sub-optimal from a financial perspective). Even so, they often need to reassure clients of the math and their agreed-upon plans during times of stock market declines when fear is running rampant.
I am not a fan of paying for professional management of your investment portfolio since it typically comes with an amazingly expensive 1% fee, which is 25% of your spending if you follow the standard 4% withdrawal method! However, if you really need the emotional support to stay the course during inevitable stock market declines, it can be well worth the cost. Dalbar Inc, a company that studies investor behavior, indicates that the average retail investor earned a return of 5.19% versus a return of 9.85% for the S&P500 over the last 20 years (ending 12/31/15). This is solely due to bad timing on investment changes due to fear. If you can get 8.85% (9.85%-1% fee from your advisor) because the advisor prevents you from doing stupid things, then you still end up 70% better off (3.66% above the 5.19% average (3.66/5.19 = 70%)) than the average retail investor, even after the significant advisor fees. So for many, an advisor can certainly be worth their fees despite the bashing you see them get in the FIRE community. Update: I’ve recently seen some compelling research challenging the Dalbar Inc. methodology. Because of the timing of investments and market gains/losses during the periods studied, a bias is created that makes individual performance look much worse than it actually is (at least over the time frame studied). After correcting for this, it turns out individual investors, in total, don’t underperform the market by any appreciable amount. Certainly many investors do make poor emotional decisions and end up underperforming but it appears this is less an overall problem for stock market investors than is often conveyed. This also means there is even less of a case for using an expensive financial advisor so my comment below is even more relevant.
But there is a much better option that will make you at least 25% more wealthy over time. Do it yourself (i.e. avoid the 1% advisor fee) by mastering your emotions through knowledge and experience.
Let’s go back to our professional financial planners. How do they manage risk with their clients? One of the simple first steps is to create some buckets of savings based on different goals. This is a pretty easy step for short-term needs like saving for a house down payment in a few years. Here, you need the money in a liquid investment that will have a stable value. However, the really big and most costly goal that everyone has is retirement (college for the kids is also a longer-term goal but even that cost is small compared to retirement). This now becomes more complicated. People have a hard time grasping large numbers far in the future. But it’s important to understand how a client thinks about this in order to create a plan the client is emotionally satisfied with. In particular, they need to understand how much fear of investing the client has, i.e. their “risk tolerance”.
Here is where things go wrong. Financial planners want to make money. They are also genuinely trying to help their clients (hopefully!). But the biggest barrier to helping their clients is usually the clients themselves. Particularly their fear. They won’t have a very successful business if their clients are unhappy because they feel the advisor talked them into taking more risk than they can handle emotionally. When their investments drop, even if it was all explained beforehand, most clients will be very stressed and angry and will often blame the financial advisor for misleading them.
So financial advisors use questionnaires to understand the client’s “risk tolerance”. If you look at the questions though, what you find is that they are centered around the emotional ability handle short-term risk (i.e. volatility). But we have a really, really big problem here.
Most investors and professional financial planners, particularly those creating investment plans for a time horizon of more than ten years (i.e. anyone younger than ~80 years old), are focused on the wrong risk of short-term volatility. This sort of makes sense if you want happier clients. But it doesn’t make sense mathematically if your goal is to maximize long-term investment gains, which is the goal of most investors and absolutely critical for early retirees who need their investments to work for them for 50 or more years. In longer timeframes, you don’t want to depend on depleting your capital to fund your expenses. You need your investments to generate your spending money so that your initial capital lasts an extremely long time, or even grows during retirement.
Focusing on short-term volatility is the wrong approach
When people think about risk in the stock market, they almost always focus on short-term risk. How will you handle a year where your investments drop 10%, 20%, 30% or more? Can you sleep at night? Would you sell (after a substantial decline) to “ease” your mind and prevent ongoing pain? These are certainly important personal psychology elements that you need to understand about yourself to be a good investor. The top investors like Warren Buffet credit the majority of their success to being unemotional about their investments. It’s critical to understand that our (very normal) emotions cause big problems in our investing success. The big problem is that short-term volatility, which generates such strong emotions, is not our main risk.
Everyone has all these strong emotions over short-term volatility, something that actually doesn’t matter that much in terms of the risk to their financial goals.
Whether the stock market goes up or down a lot in a given year actually doesn’t matter. What we need to focus on emotionally and in our investment plans, is the long-term returns. I admit this is incredibly difficult to do emotionally, but if you can master this, you are way, way ahead of the game. The only way I know how to master this is through knowledge and experience. As I showed in 2016 and the Last 10 Years in Review -Money Fun During the Final Stages of the Journey to Financial Independence, where I showed our investment returns over the last decade (we were almost fully invested in the stock market over that period), you can see the great year-to-year volatility in returns. But over that decade, including the 2008 financial crisis, our investment gains were a very nice 8% compounding return that contributed a significant portion to our personal wealth gain. The way I achieved that was by mastering my emotions during that time by learning about investing and having confidence in the history and math of investing. This let me stay the course in the market and not take the wrong action of selling when fear was high.
In investing, when you feel a really strong urge to do something with your investments, it’s usually the best time to do absolutely nothing.
2008 is a great example of high investing emotion. During the financial crisis as I saw our investments nearly cut in half, with days and weeks of continual, painful losses, I kept fully investing any excess income from our paychecks and I even invested any spare money I could find, including our emergency fund. I stayed fully invested the whole time because I knew our time horizon was long. There was a real feeling at the time that the entire system would collapse. This was a real possibility back then. But as my wife and I discussed at the time, if that really happened, the size of our investment portfolio would not be our biggest concern. The entire world would be collapsing. If we really thought that would happen, we should be liquidating all our accounts and buying canned goods and ammunition. I felt there was a high probability of us feeling foolish in a few years if we actually took that course of action so we decided to stay invested 🙂
In the end, it was a great thing to face a big decline somewhat early in our big savings years. Anyone starting out or in the middle of the accumulation phase of building their net worth should pray for a terrible bear market. It’s the best thing that could happen to you. My only regret is that the market recovered so quickly in 2009. It would have been much better if it had taken several years so I could have saved more of my steady income and had more money in my investments to benefit from the stock market gains.
Our TRUE RISK for long-term financial needs.
So if volatility is the wrong measure of risk, despite the fact that most professional financial planners and individual investors focus on it, what is the TRUE RISK we should be planning around?
The real risk to our life-long financial success once we stop pulling in a wage income (and hence depend on our savings to cover our expenses) is the risk of poor long-term returns.
This risk completely dwarfs the risk of short-term volatility.
Mathematically, a retirement that is 50+ years, is not much different from one that is forever. This means your investing and withdrawal plans need to be built around the idea that your investment gains need to fund your expenses. With such a long timeframe, you can’t count on drawing-down your principle to give you much spending money. This can work okay for a more traditional retiree who has maybe 20 years to live after retiring at 65, but not someone who retires in their 50s or earlier. Although even in the traditional retirement age case, with lifespans so high now, you see more professional advisors allocating a larger % to longer-term, high-returning investment like stocks, usually around 60% which is a lot higher than the old 100-age formula for stock %.
If you don’t have a large portion of your savings in investments that will provide a good long-term return, you run a real risk of running out of money down the road. It’s the death of a thousand cuts as your expenses dig into your principle a little at a time over a long period until you are in trouble. This is slower but analogous to the sequence of returns risk where if you draw down your principle too much in the early years, even good investment gains later might not be enough to save you financially.
So we need investments that deliver good long-term returns, particularly in relation to inflation. In other words, we need to achieve good real (not nominal) returns. A simple way to look at this is by comparing your “safe” withdrawal rate plan to your expected long-term investment (real) returns. This is where the results from studies like the Trinity study, which first determined the now-commonly used 4% safe withdrawal rate, came from. Stocks over the last century in the US returned an average 6.5% real return. Bonds provided less but still good real returns. A 50/50 portfolio, regardless of the starting year of “retirement”, was able to survive a 30 year retirement, albeit by using the principle at times (note that success was claimed as long as you had 1$ left after 30 years). In most cases, due to the range of stock market returns year to year, a retiree would have been fine with even a 6% or higher withdrawal rate. Another way to view this, in ⅔ of the cases, using a 4% withdrawal rate at retirement led to significantly higher real portfolio compared to the starting portfolio. However, since stock market returns are very volatile, the timing matters. The combination gave rise to the 4% rule as the “safe” withdrawal rate that worked even in cases where the person retired right before a bear market.
It’s important to note that there are a few significant problems with the 4% rule found through these earlier studies.
One is the 30 year timeframe. Early retirees need a plan that is often 60 years and this changes the math. Also, success was claimed as long as you didn’t run out of money at year 30. Several of the “success” cases would be deemed failures if money was still needed in year 31 and beyond.
In terms of stocks, stock market returns were amazingly good in the US during the last 100 years. This is despite some pretty big negative things from the great depression to several large wars but a lot went right for america during that time as well. The data isn’t quite as good if you look globally. Wade Pfau, a popular financial retirement expert, has studied this and found that the 4% rule would have been closer to the 3% rule in most of the markets outside the US, with many countries performing significantly worse.
In addition, stock market valuations in the US right now are high, which tends to result in lower returns over the next decade.
Another significant factor is that bonds delivered good returns in the past. Over the last several decades (since the 70’s), bonds have been in a long secular bull market as interest rates have slowly declined, boosting the value of bonds. But interest rates can’t go much lower and current yields on bonds are terrible. Even long-dated bonds are giving real returns near 0%. So if your strategy is based on 100% bonds, you need to plan for a 0% safe withdrawal rate (so yes, you can never retire). Plus they carry interest rate risk where they drop in value as interest rates rise, particularly long maturity bonds. Since interest rates are at a very low historical value, they are more likely to go up than they are to decrease significantly. I am not a big fan of long-term bonds at all in this current environment. I’d rather hold cash or very short maturity bonds for any short-term spending needs.
So where does this leave us? If you are planning to use a less “risky” portfolio by having a substantial bond portion, say the somewhat common 50% bonds, 50% stocks allocation recommended to many upon retirement, and you’re counting on the standard 4% safe withdrawal rate, I’m afraid you have a very risky plan, particularly if you’re planning a retirement longer than 10 years. With bonds currently yielding around 0% real returns, and stocks forecast to deliver lower future returns (estimates vary widely but I believe a 3-5% real return range is the best to use right now), your safe withdrawal rate is only in the 1.5-2.5% range.
So this is depressing. 4% worked in the past and now we have to plan around something like 1.5%? So we need to save up 2x or more the nest egg compared to the past?
So we want to retire early, but we have to save up so much that it’s impossible to do so?
This is where a big tilt to stocks come in.
So a 50/50 stock bond portfolio leads to a SWR of maybe 1.5-2.5% but a 100% stock portfolio would give maybe a 3-5% SWR even with lower estimates of long-term stock market returns versus what was achieved over the last 100 years. You can quibble over the exact estimates but there is no denying that current “safe” investments are providing terrible current and estimated returns. If you rely on them, you need to have a much lower withdrawal rate or you are taking a big risk with your financial future.
I won’t go into all the calculations and details here. If you’re interested, Early Retirement Now (ERN) has a very nice, detailed series they just published on safe withdrawal rates including most of these considerations (minus an international vs US stocks consideration). ERN Safe Withdrawal Rates Articles. Check it out if you want to delve into more detail
So invest more into the stock market and less into bonds. Stocks are more risky (again, mistakenly looking at mostly short-term volatility as risk) so investors demand a “risk premium” over bonds. Historically this risk premium has been 3.5-5.5%. This is pretty amazing. Compounding this type of extra return over long periods of time makes a huge, huge difference.
Remember that we add bonds to the portfolio to decrease risk right? But again, the risk we’re talking about is the short-term risk. It’s the fear you feel when your stock investment portfolio drops by 10, 20, 30% or more. Your bond portfolio shelters you from that gut-wrenching decline. But we already covered why this short-term risk is not your TRUE risk. The real risk to your financial future is the risk of long-term poor real returns. Right now you are guaranteed that with bonds. Adding bonds actually adds risk. Yields are simply terrible right now.
The only way around this is to put your savings into higher returning investments like stocks or real estate. I still recommend targeting a 3% SWR for those planning for FIRE since valuations are high and long-term future returns are expected to be lower, plus we need a longer timeline to spend money without working. It’s not as pleasant as a 4% SWR, but it still requires half as much savings as 1.5% does!
Naysayers might point out that the rise of the 100% stocks crowd is due to recency-bias. Stocks have done well over the last 5 years so people are jumping on the bandwagon. There is some truth to that but I don’t think that is a big factor.. In the not-so-distant past we also have had a few big crashes that made a lot of people hate stocks so it’s not like people have forgotten that stocks can decline quickly unexpectedly and significantly. In addition, the people who are avocating this, including myself, have been doing this for a while, including through tough times like the 2008 financial crisis.
I try to look at things objectively. What are stocks? They are ownership stakes in businesses. Businesses with hard-working people who are trying to increase profits every hour of every day. They are trying to improve productivity, invent new goods and services, and gain business. They pass on price increases (i.e. keep up with inflation). They are working hard to grow earnings. This earnings yield, plus the dividends that stocks deliver (~2% dividend yield right now), are the two main components of business (stock) returns to investors. These are real things because businesses make money. It’s their main purpose.
The last important factor of stock market returns is the change in the P/E ratio, which is simply a psychological change in how much investors will pay for the same level of earnings. While things like profits and P/E ratios can be incredibly volatile on a year to year basis, the premise that businesses will continue to find ways to create value, improve productivity, and grow earnings does not change. I believe technological and human progress will continue to be made. I don’t find ownership in a diversified pool of businesses (i.e. broad index finds including international diversification) to be risky for the long-term at all.
Yes, these investments are incredibly volatile at times, but they are not risky from a long-term perspective because they are the most likely to outpace inflation over time. That is the major consideration/risk for early (and many normal) retirements because it’s the excess return over inflation (i.e. the real return) that provides the ongoing spending money throughout your retirement.
If you profile many of the successful FIRE bloggers out there, you’ll find many of them have a very high asset allocation in stocks (or rental real estate which is similar) and little in bonds. This is no coincidence. Again, most of these have been retired for a while and experienced the big 2008 stock market decline, but are still doing well. Mr. Money Mustache, Financial Samurai (more real estate focused), Go Curry Cracker, JL Collins are some of the more famous examples. I can’t think of any success stories of people who saved a lot from their jobs and retired early while investing their savings primarily in bonds or some other “safe” investment.
Bonus topic: Sequence of Returns Risk
One important topic I didn’t cover in this article is the so-called sequence of returns risk. This risk essentially states that the order of good and bad investment returns after retirement play a key role in your financial success or failure. Here is where the short-term volatility of stocks does matter. If you happen to hit a few years of bad returns right after retiring, you need to draw down on your principle to pay ongoing expenses. If the good investment returns come too late, you could end up in a death spiral where your ongoing expenses are more than the returns your portfolio is generating.
Generally this can be considered a short-term risk of a few years since the average bear market lasts 18 months. I should note that it is possible to have a very extended period of poor real returns like the 1970’s but there are few effective ways to protect against that so you’d either have to try to find work again or reduce your spending to make your money last. Neither stocks nor bonds are effective in a time of high inflation and poor investment returns (stagflation). The only thing you can do is inflation-protected instruments like TIPS which is not a bad idea for those that are already old and retired. But outside these rare long-term real declines, most stock market declines are relatively short-lived. However, they are substantial in magnitude.
The best way I know to deal with this is to have liquid short-term money available for ~2-3 years worth of spending. You can use cash or very short term bonds. You can also be creative and use things like a HELOC (home equity line of credit) to give you spending money in the event of a large market decline. You won’t keep up with inflation with this money but it doesn’t matter, it’s a cushion against a significant stock market decline so that you don’t have to sell your stocks after a big decline to pay for known short-term expenses. This cushion gives you time for the markets to regain some ground before needing to sell for spending money.
Keep in mind that in order for this strategy to work, you need to use this cash cushion when it’s needed. Too many people become afraid during market declines and then want to keep the full cash cushion during those times. This doesn’t help at all. My own plan is to keep 3 years of spending money in liquid cash once I’m done bringing in a paycheck. Once stocks hit a decline of 15% (declines of less than this occur too often to be a useful trigger point), then I will stop selling stock gains for spending money and start using the cash cushion. I will continue using this cash cushion until stocks are back to break-even or the cash cushion is completely drained. When stocks have recovered, I will go back to using stocks for spending money and slowly rebuild the cash cushion. The timing of rebuilding the cash cushion will depend on how fast the stock market gains value.
Ironically, this small portion (~10% of your portfolio) will be your ultra-safe short term portion (but highly risky long-term) so that you can take significant short-term risk (but lowest long-term risk) with the remaining 90% of your portfolio in stocks.
This mix of ultra-short term and ultra-long term is better than intermediate-term investment options like 10 and 20 year bonds that are the worst of both worlds unless you are late in life and just want a safe income stream at the expense of long-term improved returns (e.g. a bond ladder for income is a good idea in your 70s).
I realize this article has now passed 4500 words and my wife just reminded me that people don’t like to read articles this long so I will wrap up. For those that made it this far, I hope this long article provided some benefit. It’s a topic I’m passionate about and I believe understanding these factors better has greatly improved my mindset on investing and will significantly aid my financial future. I hope you find a similar benefit.