Investing 103: Risk and return in the stock market
Investing in the stock market can be unnerving. It’s not like buying a car where you can kick the tires. It seems like the only thing you get with your investing dollars is a little digital number on your brokerage statement called “quantity of shares.” Then, the price of those shares can start flying around, and can seem out of control. This post is a quick dive into a couple features of the stock market: return and risk. More importantly though, is how our emotions of greed and fear are entangled with return and risk.
Editorial note: I originally wrote this post in January 2017, but the message is still relevant today. So, I’ve re-posted.
An analogy for the stock market is a yo-yo on an ascending escalator (where the height of the yo-yo is the price of the market). Over time, there is an expected movement, the escalator. This steady, upwards hum is basically understandable: the global population increases, inflation is real, businesses sell more and more stuff to more and more people. The escalator analogy can sort of explain why the stock market (or more accurately, the businesses that make up the stock market) has historically produced a return of around 10% per year.
But, the yo-yo is unpredictable. Sometimes the player smoothly moves the yo-yo up and down, maybe walks the dog. But sometimes the yo-yo hits a a knee and falls down. Hopefully, it doesn’t drop and get stuck in the escalator treads. Changes to interest rates, monetary supply, investor sentiment, elections, even whimsy can all contribute to the yo-yo’s stuttering, swinging movement. In financial markets and investing, this movement is called risk, or variability.
The tricky part about variability is that although there are two directions (up or down), our reactions are very different.
Sometimes the yo-yo goes up and we tend to exclaim,
“Awesome, my stocks are hot!” or “my investment advisor is kicking ass!”
At other times the yo-yo goes down. Our reaction during those times tends to be,
“Stocks are terrible investments, I got burned!” or “My investment advisor is killing me!”
Behavioral finance suggests that humans are “loss averse.” We react more strongly to unexpected losses than to unexpected gains. It’s probably deeply rooted in our history. Losses are painful, like going hungry. Gains on the other hand may just feel like extra food. We are likely more concerned about going hungry than about our where to store our excess food.
When the stock market drops, many investors can feel a pit in their stomachs. They may grow concerned or fearful, they may even panic and sell their investments. Hoarding in a time of famine is sensible. However, ups and downs are a natural part of stock markets. If your money is for the long-term, then it is better to historically, the market has gone up two out of every three years, those “panicked investors” can easily lose out on future gains.
Warren Buffet said the most important skill he mastered in becoming a highly successful investor was his temperament. He quipped this advice:
Be fearful when others are greedy, and greedy when others are fearful.
Easier said than done. Although it is sound advice, studies indicate that most investors do the opposite.
Investing and planning implications
Sometimes the stock market seems expensive. Sometimes it seems cheap. Politicians change, interest rates go up and down. It is difficult, or even downright impossible, to predict the future movements of the stock market. I tend not to act based upon macro-economic concerns or excitement. I am a fundamentals focused investor. Before I invest my own, or client’s money, I create a strategic “Investment Policy Statement” or IPS. It is a plan for a portfolio, based upon a person’s individual circumstances such as time-frame, liquidity, and risk capacity. Then, I select appropriate investments based on underlying characteristics of the investments, be they diversification or low fees in the case of an index fund, the revenue, profits and debt position of an individual company, or the creditworthiness and duration of a bond.
Commercial break. Enter a scene of mountain and hikers, with a low, dusty narrator voice – “When weather is calm, any hiker can reach a summit. However, when a storm blows in, you need knowledge and preparation: route-finding skills, good equipment, fitness.” Investing is similar. Making money in the stock market seems easy when the markets are rising. But you should prepare for weather. Be sure your invested dollars are intended for the long-term, that you have a healthy short-term emergency fund, and that you don’t have too much debt. These are the elements of sound financial planning. As for investments, in times of rapidly rising stock markets, I try to slowly increase cash within a portfolio to prepare for future investment opportunities. If the stock market drops, I want to be ready. That is what happened in 2007-08, a terrible year for the stock market, but a great year for an investor looking for bargains. End of commercial break.
In 2016, our family enjoyed some “fruits from investing” on our half-year sabbatical in Asia (thanks Apple and the iPhone!). We called the adventure “Four4Four, Cheeseburgers in Asia.” You can read about our travel exploits on our blog (click on photo to open a new window):
What if the escalator breaks down?
In general, if you want to strive for higher investment returns, you need to accept a higher level of risk. In other words, if the escalator is steeper and faster, it’s easier for things to break down. But, given a long enough time horizon, even broken elevators tend to get fixed. Why? Global population increase. Savvy business leaders. Inflation. Price-adjustments to products. Returns on invested capital. Et cetera.
My advice is to create a strategy. I don’t know who coined this phrase, but it is wise advice:
Investment returns are built from time in the market, not timing the market.
I agree. Create a map. Use a compass. Even if the weather get stormy, or a season is unbearably hot and fruit is withering on the vine, you can look at your path and your map. A good adventure will inevitably run afoul of some foul weather. Have a good plan, and stick to it.