Stocks are far less risky than you think. The advantages are to stick with equities over the long haul.
Most people try to reduce risk in their investment portfolio by seeking safe havens like bonds. The others do so by moving money out of the parts of the market that scare them at some moment.
But what if the best way to minimize risk is to simply buy and hold stocks for the long run?
Some new research suggests that stocks become less risky the longer you hold them. The research suggests that “set it and forget it” could be good investment advice. Also, you should overweight your portfolio toward stocks. No matter if you are a young investor or in the age when most of the people are becoming more conservative.
Well, it is not only risky to invest in the stock market but it is riskier not to invest in the stock market.
We are going to start with the risk of NOT investing in the stock market.
If you have savings you have to do something with it. You could put it in a savings account. The interest you get is taxable and less than the rate of inflation so over time you will actually have your savings go down in value but they are fairly secure.
You could put it in bonds but as the interest rate goes up, which is expected, the face value of the bonds would go down so you could lose money. If you go that route go only with short term bonds. You could invest it in real estate, maybe rental properties. We know some landlords and they would never do it again. There is a risk but some have done very well in real estate.
Of course in an economic downturn, you could end up with empty properties or non-paying tenants. That means you would have to make the mortgage payments with no rent coming in.
But we have to say that investing in stocks can be risky.
There are stocks that can burn a big hole in your pocket.
There are so many reasons why some investors believe that stocks are riskier the longer you stick with them. Some of them have the idea that the longer you stick with a portfolio, the more market rotations, downturns and corrections you will live through.
The market is rollercoaster! There are no guarantees that it will be up or even back to your starting point when the time comes that you have to get off.
The longer you are in the market, the more uncertainty you face, so many people translate “uncertainty” as “risk.”
The worst-case scenario of stock markets is a free fall (stock market crash). The one we saw in 2008. No one knows when it can happen. It is only wise to understand the current economic situation and invest in the right places and to move out at the right time.
There has always been a wrong notion that everyone who invests in the stock market loses money, this has to change. When you choose to invest in the right companies at the right time, the stock market is among the good assets creation classes.
You’ve heard of diversifying into various asset classes and across the international scene.
The theory behind the new research involves “time diversification,” an opinion that experts argue over, with some implying it’s real and important and others saying it doesn’t breathe. The time diversification simply suggests that the longer holding period effectively diminishes the effect of any short-run period. That has happened to folks who rode out the financial crisis of 2008 by holding with the market through its ups and downs to get to its recent highs.
The belief that “time heals all wounds” is certainly an illusion when it comes to investing, but it may benefit investors, nonetheless. If the risks borne by diversified equity investors are to be rewarded, as they have been historical, then the largest portion of the payoff for that risk might reasonably be expected to follow periods of market difficulty, when the risk of loss may be perceived to be great.
Over time, risk premiums will vary with the current, as well as the expected, investment environment, and lower current prices suggest higher risk premiums and higher relative future returns.
The belief that a sell-off in equities is a short-term event in an otherwise long-term investment horizon may reinforce investors’ convictions in their strategic asset allocations. Also, it may help them overcome a reluctance to rebalance their portfolios.
Often, a very long investment horizon implies that an investor is in the initial steps of building wealth. In that case, the investor’s portfolio is typically small relative to his future wealth, and the portion of his portfolio represented by capital contributions is large. As a result, in the early stages of investing, portfolio growth depends more on contributions than market returns.
You would assume that in theory, holding a diversified portfolio of cash, bonds and stocks creates the most quantity of property 20 years from now. That actually isn’t the case. The history shows, holding stocks over a long time has been the optimal thing to do. This effect of time diversification has been increasing, so the profits to long-term investors have been growing over the last 110 years, not decreasing.
So holding stocks is actually a better thing to do.
The research does not modify the fact that we will have good and bad times to buy stocks. It just points out that investors profit from being more aggressive in the extended mix of stocks/bonds/cash. This research suggests going more in the direction of stocks than you might otherwise have been a tendency.
Bonds are riskier than stocks for long term investors, for example. Here’s why.
Most people think of investment risk as to the chance that a given investment will lose value in the short term. You can certainly reduce the risk of losing money in the short term; just put your money in a savings account.
Risk and reward are intertwined, and therefore, the risk is integrated into all financial instruments. As a result, smart investors seek to minimize risk as much as possible without reducing the potential rewards.
Reducing all of the variables affecting a stock investment is difficult, particularly the next hidden risks.
Volatility is one of them.
Volatility does not specify the direction of a price move both up or down. It just indicates the range of price fluctuations over the period. It is expressed as “beta” and is intended to reflect the correlation between a security’s price and the market as a whole, usually the S&P 500:
A beta of 1 (low volatility) suggests a stock’s price will move in concert with the market. For example, if the S&P 500 moves 10%, the stock will move 10%.
Betas less than 1 (very low volatility) means that the security price fluctuates less than the market – a beta of 0.5 suggests that a 10% move in the market will produce only a 5% move in the security price.
A beta greater than 1 (high volatility) indicates the stock is more volatile than the overall market. Apparently, a security with a beta of 1.3 would be 30% more volatile than the market.
When some experts advocate that stocks are riskier than bonds, they are referring to what is called beta. Beta is a measure of an investment’s volatility. For example, a stock with a beta of 1 will have the same volatility of the market, while a stock with a beta of 0.5 will be half as volatile. A stock with a beta of 2 will be twice as volatile.
Here is the formula. Beta is calculated by dividing the covariance (the degree to which returns on two assets move together), of the daily percentage changes for the stock and the index by the variance (volatility from the average).
But, there are some disadvantages to doing it yourself. The main issue is time. Calculating beta yourself takes longer than doing it through a website, but this time can be significantly cut down by using Microsoft Excel or Open Office Calc.
If you use excel it should look like this
Choosing investments with low beta can retain full exposure to equity markets while avoiding painful downside outcomes.
But one important note. Reducing risk is less about concentrating on low volatility and more about avoiding high volatility.
But how to manage volatility?
You can invest in stocks with consistently rising dividends. Or by adding bonds to your portfolio. Also, hedging is a great tool.
For example, an investor with a portfolio of low and medium volatility stocks might buy an inverse ETF to defend against a market drop. An inverse ETF, also “short ETF” or “bear ETF”, is designed to perform the opposite of the index it tracks.
In other words, if the S&P 500 index increases by 5%, the inverse S&P 500 ETF will simultaneously lose 5% of its value.
When mixing the portfolio with the inverse ETF, any failures on the portfolio would be compensated by gains in the ETF.
Well, theoretically possible, but investors should be aware that an exact offset of volatility risk in practice can be difficult to establish.
But you have to know that without risks there is no reward. The risk is just the other side of the reward. If you want a bigger reward you have to take more risk.
We can recognize several types of investment risk:
Market risk. The risk of investments declining in value because of economic developments or other events that affect the entire market.
We want our stock to go up or bond to pay us or whatever it might be but there’s the risk to that.
You know, if you have cash in your pocket that’s less risky than if you invest in stocks, for example.
One of the biggest risks of investing is that the economy can go bad. Do you remember the bottom in 2008-09?
For young investors, the best strategy is to increase your position in good solid companies. Foreign stocks can be a brilliant choice when the domestic market is in the holes. Thanks to globalization, some companies earn a majority of their profits overseas.
Older investors are in a tighter bind. If you are in or near retirement, a major downturn in stocks can be devastating if you haven’t transferred major assets to bonds or fixed income securities.
Speaking about inflation, investors historically have retreated to “hard assets” such as real estate and precious metals, especially gold, in times of inflation. Inflation hurts investors on fixed incomes the most since it erodes the value of their income stream.
Stocks are the best protection against inflation since companies can adjust prices to the rate of inflation.
A global recession may cause that stocks will struggle for a protracted amount of time before the economy is strong enough to bear higher prices. It is not an ideal solution, but that’s why retired investors should keep some of their assets in stocks.
Few words about the conservativity.
There is nothing improper with being a traditional or conservative investor. But, if you never catch any risk, it may be hard to realize your financial plans. Maybe you have to finance 15 to 20 years to retirement. Keeping it all in savings instruments may not get the job done.
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