Your Biggest Investment Risk

Your Biggest Investment Risk

You may be familiar with the World Economic Forum’s (WEF) annual meeting in Davos, Switzerland, where leaders from around the world meet to discuss the most pressing issues facing our collective societies. The WEF produces a Global Risks Report summarizing the results, based not only on the discussions at the meeting but also on feedback from hundreds of economists and other global specialists. One of the biggest risks highlighted in the 2019 report was not the possibility of a global recession, or trade battles, or unemployment. Rather it was the risk of nuclear war using weapons of mass destruction. The logic behind this has application to your investment strategy as well.

The WEF report did not suggest that nuclear war is imminent or likely. The reason for their putting it at the top of their list is because the consequences will be devastating. We use the same type of thinking when purchasing insurance. It doesn’t make sense to insure against events that occur with high frequency (such as health care for managing a cold) because the cost of the premiums would be too great. Instead we use insurance to protect ourselves against those rare occurrences (earthquakes or car accidents, for example) having a low likelihood of incidence but a big impact on our lives or on our pocketbooks.

When it comes to investing, investors commonly use averages to make decisions. The problem is that averages mask extremes. For example, over the last 45 years, a portfolio comprising a mix of large company, small company, and international stocks would have gained on average about 10% annually. On the surface that’s a pretty good return. A $10,000 investment in such a portfolio would have grown to almost $730,000 today (excluding taxes). However, in 2008 the value of that portfolio would have dropped by about 40%. That would have represented a loss of over $150,000. Investors expecting an average annual 10% return on such an investment would have been shocked.

As I have written before, there are various measures such as standard deviation, Sharpe ratio, and Sortino ratio that financial advisors utilize to provide an indication of how bumpy the investment road had actually been (see
https://www.cognizantwealth.com/2018/04/17/whats-the-real-risk-in-your-portfolio/). But such data may be hard for many of us to internalize. For example, the standard deviation of the above portfolio over the last 45 years was about 17%. That means about 2/3 of the time the return had been between minus 7% and plus 27%, and most of the time between minus 24% and 44%. Those ranges are broad enough to make it hard to figure out just how much you stand to lose. In fact, you would have lost 40% in 2008 which is well outside even the wider range.

If you are going to use historical data for investment decision-making, I recommend researching not just the average return but also the biggest loss. That won’t tell you how much you could actually lose, but at least provides a benchmark that you can use to determine its impact on you. If it’s a loss that you cannot bear, either financially or psychologically, then you should consider a different investment strategy.

Also try not to worry about nuclear war.

Here’s a link to the WEF report: https://www.weforum.org/reports/the-global-risks-report-2019.

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