Investment Risk

On 20 April 2022 I happened to look at my stock app and I did a double take when I saw Netflix (NFLX) dropped 35%!  This was a real reminder of individual stock risk.  Many people think of stocks as risky investments, this Netflix drop would support their case.  I would like to explain basic investment risk, how to mitigate risk and how diversification and allocation can help to reduce investment risk.

What is Investment Risk?

Per Merriam-Webster, Risk is: The chance an investment (such as a stock or commodity) will lose value.  Warren Buffet’s #1 rule of investing is “Never Lose Money”.

Investments Types by Risk

Low risk investments – Cash, Money market accounts, Government bonds, CD’s, Short and intermediate term bonds.

Medium risk investments include – Large-cap stocks, REIT’s, Mid-cap stock, High-yield bonds and Small-cap stocks.

High risk instruments include – Foreign stock, Micro cap stock, Commodities, Options, Futures, Limited Partnerships, Alternative Investments, IPO’s, etc.

Low risk investments historically do not keep up with inflation so we must look elsewhere to grow wealth.  Many investors do not have the risk tolerance or knowledge for success in the high-risk category.  For these reasons the smart investor will focus on the mid-risk category of US corporate stock. 

According to NerdWallet the average annual stock market return is 10% https://www.nerdwallet.com/article/investing/average-stock-market-return.  This is in line with the S&P 500 historic returns but a bit above the Dow Jones historic average return.  Along with the compounding effect a 10% average return can help any investor grow wealth.

Company stock risk comes in two basic forms:

Systematic risk – Market risk or things that generally affect the market as a whole.  Things like inflation, recession, interest rate changes, political factors, etc. 

Unsystematic risk – Risk unique to an individual company.  Examples would be Elon Musk making a bold statement to the news media affecting Tesla’s price or Netflix servers crashing causing loss of subscribers, Kodak not getting into digital cameras etc.

With this basic understanding of both basic stock investment risks, you can see the average investor has no control of either.  So how do we reduce this stock risk?

Mitigating Investment Risk

If you invest 100% in Tesla stock and Elon Musk announced he believes in aliens and the tooth fairy the stock could fall to zero.  You then lose 100% of your investment.  But if you owned 50% Tesla and 50% IBM your total loss would be reduced to 50% because IBM didn’t fall.  To reduce that even further spread your investing over more stocks.

So why not buy 500, 1000 or 3000 stocks and reduce your risk even further?  When you buy an index-style mutual-fund you are doing just that.  Now if Elon makes a crazy claim his share of your total becomes almost insignificant.  You still share in the systematic risk of the market but unsystematic risk is minimized.

What do you give up when buying “the market” in large index-funds?  You give up the highest returns if you had only owned the top performing stocks.  You still benefit from their return but you have to average those returns with the lesser performing holdings.

So why not just buy the top performers?  The data indicates even the best investors can not pick the top performers year after year.  You can’t pick them either!

Diversification and Allocation

Diversification – spreading risk over a number of assets within a given asset class.

Allocation – Balancing the different types of assets classes based on goals, time and risk tolerance.

I’ve already discussed that owning an index fund buys hundreds or thousands of stocks.  An S&P 500 fund like Fidelity’s FXAIX automatically diversifies (~500 stocks) your stock holdings within the large-cap asset class.  If you were to own Vanguard’s VTSAX fund you would own over 4,000 stocks and cover large, mid and small cap asset classes.

If you have over 5 years to grow your wealth and a good risk tolerance, I think a 100% stock allocation might be just fine.  But if you are near or in retirement or don’t like to see big value swings you should look into a different allocation.

If you have read about the 4% rule https://www.1engineeronfire.com/?p=57 you know to survive a long withdrawal period you need an allocation mix of stocks and bonds.  The well-known “Trinity” study https://www.aaii.com/files/pdf/6794_retirement-savings-choosing-a-withdrawal-rate-that-is-sustainable.pdf can help you with allocation selection as well.  For this you have to look at where you are, where you want to be and then honestly assess your risk tolerance.

The trick with any allocation is you need to stick with it.  You can’t claim to be an aggressive 100% stock investor and then sell out when the market drops 30%.   This will guarantee failure!  You also need to understand $50,000 will only grow to about $103,000 in 10 years in a conservative 40/60 stock/bond portfolio.  I like this chart I found at optimizedportfolio.com.  At a glance you can see the average expected rate of return with various allocations.

The bars represent the best and worst one year returns for each allocation from 1926 thru 2019.  One way to set your allocation is to look at the worst return (number at the bottom of the bar) and ask yourself if you can tolerate that amount of annual loss.  For example, if you think a 25% loss in a single year would have you selling then you better not have more than a 50% stock allocation.  If you have 2 decades before you need your money and you can ride out a 40% loss then you might be able to tolerate 90% stocks and can then expect 10% returns.

Of course, there are many variables and this is all based on past performance.  Bonds are currently underperforming historical data so maybe add 10-20% more stocks to be a bit more aggressive.  If you think you will exceed your portfolio needs, have a pension to fall back on or plan to supplement income with work I’d go more aggressive as well.  If you are conservative and will have more than enough to meet your needs, stay safe and allocate 40% to 50% bonds.  I would not recommend more than 75% bonds for the most conservative investor.  It’s just too hard to keep up with inflation when returns fall below 7%.

What does 1EngineerOnFIRE do?

Throughout my working years my allocation was 100% stocks. I new I had strong investing discipline and would not sell in a down market.  I dollar cost averaged monthly in my 401-k and bought IRA’s every year until I was well ahead of my goals.  In the months leading up to leaving the workforce I did move ~10% of stock to bonds. 

Now 2 years into retirement I’m slowly rebalancing to an 80/20 stock/bond allocation.  I make quarterly withdrawals from my portfolio (3.1% annual rate).  That 80/20 allocation should result in a 9.6% average return.  Well above my 7% long term goal!

1EngineerOnFIRE