Redefining Risk
Risk was the chance that you might not meet your long-term investment goals. And the greatest enemy of reaching those goals: inflation. Nothing is safe from inflation. It's major victims are savings accounts, T-bills, bonds, and other types of fixed-income investments.
Investors usually use Treasury bills as their benchmark for risk. These are considered risk-free because their nominal value can't go down. However, T-bills and bonds are in fact highly risky because of their susceptibility to inflation.
For example, if you buy a 10 year-T-bill that pays 3 percent in interest per year, and inflation is creeping up at, say, 2 percent per year, the real value of your investment at maturity will end up being significantly less than 3 percent greater than the price you paid for it. In the case of low-interest-paying T-bills, higher inflation could even mean that your investment loses value, in terms of real purchasing power, over its lifetime.
Realistic definition of Risk
A realistic definition of risk recognizes the potential loss of capital through inflation and taxes, and includes:
1. The probability your investment will preserve your capital over your investment time horizon.
2. The probability your investments will outperform alternative investments during the period.
Why Volatility is not Risk?
Traditionally, investors view "risk" as being synonymous with "volatility." They believe that to get higher returns, they must be willing to stomach bigger short-term swings in a stock's price.
There is no correlation between this volatility-related-risk and return.
- Higher volatility does not give better results, nor lower volatility worse.
- Studies have shown that there is not necessarily any stable long-term relationship between volatility-related-risk and return, and often there is no relationship between the return achieved and the volatility-related-risk taken.
So if volatility is not risk, what is?
The major risk is not the short-term stock price volatility that many thousands of academic articles have been written about. Rather it is the possibility of not reaching your long-term investment goal through the growth of your funds in real terms. To measure monthly or quarterly volatility and call it risk - for investors who have time horizons 5, 10, 15 or even 30 years away - is a completely inappropriate definition. (David Dreman)
In the short-term, stocks fluctuate unpredictably, so if you're saving to buy a house or a car within the next two years or so, bonds and T-bills are a good choice. But over the long term, stocks far more often than not outperform alternative investments like bonds or T-bills.
In fact, Dreman's research shows that inflation-adjusted returns for stocks - which, unlike bonds or T-bills have the ability to produce increasing earnings streams - have consistently outpaced those of bonds and T-bills since the start of the 1800s. The gap has widened since the mid-1920s, when inflation began to have a more significant impact.
What's more, from 1946 to 1996, according to Dreman, compound returns after inflation for stocks were better than those of bonds 84% of the time if your holding period was 5 years.
- Stocks also outperformed T-bills in 82% of those 5-year periods.
- Using 10-year periods, stocks beat bonds 94% of the time and T-bills 86% of the time.
- When you look at 20-year holding periods, stocks beat both bonds and T-bills 100 percent of the time.
Take Home Lesson
Using Dreman's definition of risk, stocks are actually the safest investment out there over the long term.
Investors who put some or most of their money into bonds and other investments on the assumption they are lowering their risk are, in fact, deluding themselves.
"Indeed, it goes against the principle we were taught from childhood - that the safest way to save was putting our money in the bank."
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