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Financial Planning and Money Management
Financial Planning and Money Management
Get the straight facts about: -Retirement plans -Investment strategies -Investment products -Fees and anything else that is rarely discussed by the financial industry.
Blog By:
Kon Litovsky
Kon Litovsky

Managing Investment Risk Part 1: Market Risk

12/23/2013 5:08:36 PM   |   Comments: 0   |   Views: 5426
This chart can put everything in context:


Figure 1.  Missing ten best days.

All this says is that markets are extremely risky, with majority of gains and losses coming in a very short period of time.  So anyone planning to retire and make withdrawals better manage risk, or else:


Figure 2. 'Monte Carlo' analysis -  multiple scenarios based on past market history.

Figure 2 shows that a retiree who invests even as little as 50% of their money into the stock market will be severely disappointed if the markets do poorly.  The takeaway is that if you put your trust in the markets, you might end up short, and significantly so if the markets underperform for an extended period of time.  Some may say that his has never happened before, but the period from 2000 to 2010 happened just recently, and many people lost a lot of money, and possibly more than once.  Others may say that all you have to do is hold on for your dear life.  But S&P500 returned 0.4% in the decade from 2000 to 2010 - so this approach would have been just as bad, especially if you needed to make principal withdrawals from the market over that decade.

You also need to diversify your portfolio globally and manage investment risk.


Figure 3. Diversified and balanced portfolio.  Diversification failed in 2009 as correlations all aligned to make the stocks move all in the same direction.

The green line is a globally diversified and balanced portfolio with 50% invested in fixed income and 50% invested in stocks. As you can see, this portfolio did very well with much less risk (other curves are different asset classes making up this portfolio).  The main idea is that you can not predict when the next crash happens, so you need to limit your exposure to risky assets, as it can take a decade or longer to get your portfolio back to where it started if you invested in S&P500, which returned about 0.4% from 2000 to 2010 (pink curve).  Even today, the S&P annualized return lags that of a globally diversified 50:50 portfolio.  Please note that diversification by itself is no panacea.  It worked well in 2000, but failed miserably in 2009.  The only way to avoid being crushed by the markets is to balance your portfolio with high quality fixed income such as treasuries.   

So the most important lesson we learn from the fact that the markets are risky is that the only way to avoid getting hurt is to avoid investing the money you can not afford to lose in risky assets. The longer the horizon, the more likely we are to experience big crashes, so if you want to have a retirement, do not place your trust in the markets because historical returns are computed in hindsight, while future returns can be anything at all without any regard to past history.
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