Riding the Escalator
When prospective investors hear the word risk, their natural first thought is to perceive that to mean the possibility of permanently losing their money. However, a simple shift in the way we view and define risk can change our attitude towards accepting it which then opens the door to greater long-term performance. In the case of a well-managed and well-diversified portfolio, risk can be more accurately described as volatility, and the difference is important.
Differentiating between risk and volatility is more easily done if we picture it as playing with a yo-yo on an escalator.
Each of these blue lines represent one of the well-diversified and well-managed investment funds mentioned above, ranging from the lower-risk light-blue fund, to the higher-risk dark-blue fund, each starting immediately before the market crash in 2008 with $10,000.
Now view each of these lines as a yo-yo bouncing up-and-down in your hand while you ride the escalator, and your original $10,000 investment as the floor you are starting from. The higher-risk yo-yo has a long string, and could easily drop below the floor you started on before snapping back up, especially if it occurs shortly after you get on the escalator as it did in 2008. At times, that yo-yo will stay down for a prolonged period of time, impatience and frustration will understandably set in, and you will wonder whether you are better off just switching a less risky yo-yo with a shorter string. That is where your advisor comes in as one of the most critical things they can do is to help you do nothing at all, and simply stay on the escalator best suited to deliver you to the floor desired. As you can see, the longer you stay on the escalator, the lower the risk of that string stretching all the way back to the floor you started on, let alone below it.
It is during these drops that stocks become available at bargain prices, and your fund managers make the adjustments that contribute most to the rebound when the yo-yo finally snaps back.
Comparatively, the light-blue line will be a much less bumpy ride and will allow us to sleep better at night, but ultimately, we do not get to as high of a floor.
“Wealth is not determined by investment performance, but by investor behavior.”
Nick Murray (Financial Planner and Author) was referring to the fact that we are human, and that we have human reactions to stressors.
When our balances drop, our natural reaction is to get-out and salvage what we can, while we still can. The emotional part of our brain attempts to override the logical part of our brain that chose the higher-risk option in the first place. These emotions can lead us to sell after taking on the full brunt of the high-risk drop, and shift to a lower-risk option which will not perform as well when things inevitably rebound. Of course, this has significant negative impact on the length of time it will take to recover to our previous high. On the graph provided, picture riding the dark-blue line to the bottom in early 2009, and how long it would take to recover if we then switched over to the light-blue line. It might feel better immediately to switch lower-risk at that time, but dissatisfaction will inevitably creep in when you then see the higher-risk begin to recover without you; that is how our human behavior leads to a damaging cycle of buying high and selling low.
In the technical sense, we can logically determine that investing in the most-volatile example here will yield us the greatest returns over the long-term, but in the practical sense, that only works if we have the emotional ability to stay invested when our balances are dropping.
Selecting investments based on your emotional ability to withstand volatility, enough to remain invested when the yo-yo is dropping, is critical and will have much more impact delivering desired outcomes than the investments themselves. Investing in the lower-risk from the outset will lead to better performance than starting with higher-risk and switching to lower-risk during market drops.
An advisor should not only help you determine which investments are most suitable from the outset, but also be there to support and reinforce at every bounce.
Disclosures: It is very important to note that we are advocates of well-diversified (geographic, sector, style etc) portfolios, managed by professional teams with a demonstrable track record of doing it well; this was written (and examples created) with that in mind.
In the graph above, the higher-risk (dark blue) line is fully invested in stocks of publicly traded companies. The lower-risk (light blue) line is 100% invested in fixed-income investments, such as government and corporate bonds (debt).