One of the most common perceptions about investing is that it is risky. This is easy to state, but harder to defend when you get into the details. To decide whether or not investing is risky, we first need to think about what “risk” is. Depending on what you are investing in – and what you are investing for – there are different ways to think about and measure risk.

In broad terms, investors are seeking to reduce future consumption risks. You invest today, hoping to meet your consumption needs tomorrow, and 30 years from now.  

The most important risks investors face are as follows:

1.       The risk of total loss

2.       Volatility risks

3.       Uncompensated risks

4.       Skewness

5.       Inflation

Today, let’s take a closer look at this handful, and how each relates to your portfolio management.

What If You Lose It All?

It is common to think about risk in terms of total loss: What if I invest money in a stock, things turn sour, and – poof – my money is gone?

As scary as this risk feels, it’s actually one of the most manageable ones. While you could go broke by investing everything you’ve got in one stock, as long as you properly diversify your investments, it is much less likely. For an entire stock market (and the index tracking it) to deliver a total loss, we would be talking about a true economic catastrophe. Even if this happened in one country, it is unlikely every other country with a functioning market would experience the same.  

Bottom line, for a properly diversified investor, the risk of total loss is very low, at least as long as capitalism continues to function.

Volatility: A Rocky Ride

In contrast to the risk of a total loss, even a well-diversified investor must tolerate volatility risk. That’s why it’s the risk most professionals and financial product manufacturers mean when they describe investment risk.

Volatility is a measure of the variability in returns. A highly volatile investment would be expected to have big ups and downs. Watching your investments skyrocket and then plummet is stressful for a lot of people, and especially scary during the freefalls. But should it be? Well, it depends.

If you are investing money that you need back in the near future, then volatility can pose a real risk. In a 2018 Financial Analysts Journal essay entitled Volatility Lessons, Eugene Fama and Ken French constructed a statistical model to examine the probability of negative risk premiums over various time periods. For the equity premium – that is, the return of stocks in excess of the return on risk-free investments – they found, over a 1-year period, there might be a 36% chance of stocks making you worse off than investing in risk-free investments like treasury bills. This figure is roughly in line with historical 1-year periods across global stock markets.

For a short-term investor, those 1-year losses due to volatility can be substantial. Thus, whether or not volatility is a real risk for you depends on two things: your time horizon, and your psychological tolerance for volatility.

If you are investing money that you need within about 5 years or sooner, then volatility is an extremely important measure for assessing the riskiness of an investment. By this measure, not only can stocks be far too risky for this timeframe, bonds might sometimes be too volatile as well.

If you have a longer time horizon and a strong stomach, volatility is less relevant. That said, even for the long-term investor, volatility risk still can’t be ignored entirely. In the aforementioned essay, Fama and French found that it was still at least theoretically possible for stocks to underperform risk-free assets over longer periods of time. Over 100,000 simulated 30-year periods, they found there was still a 4.08% chance of a negative equity premium.

This is one of the most interesting insights from their essay, because there are very few 30-year historical periods in which we can observe real historical data. One important note about Fama and French’s method is that it ignores any autocorrelation in stock returns.

Historically, periods of negative stock returns have generally been followed by periods of positive stock returns. Whether or not we should rely on this type of mean reversion in estimating future outcomes is an academic debate. For our purposes, I think it is safe to say it is possible, though unlikely, for stocks to deliver a negative return premium even over very long periods of time.

Of course, on the flip side, remember, investments with higher volatility also have higher expected returns. A long-term investor with the emotional fortitude to ride out volatile markets can expect a better outcome by investing in more volatile stocks instead of less volatile investments, like bonds.

The Nature of Compensated vs. Uncompensated Risks

An important nuance is that volatility alone does not indicate higher expected returns; it depends on what is driving the volatility. There are two main types of risk that affect the volatility of an asset: compensated and uncompensated risk. Compensated risk is a systemic risk that the market prices into securities. Stock prices are, theoretically, the discounted value of future earnings.

Taking on compensated risk is sensible. You are buying future earnings at a discount. The discount is where the compensation comes from. More compensated risk means a deeper discount on future earnings, which means a higher expected return.

Uncompensated risk is very different; it is the risk specific to an individual company, sector, or country. Maybe the visionary CEO ate some rancid tuna and started making questionable decisions. A sector can be disrupted, or a country can be affected by climate change. A good example is the change in sector composition from 1900 to today in the U.S. and U.K. markets. Making a big bet on U.S. technology today is like a big bet on railroads would have been in 1900.

This sort of random, sector-specific risk can materialize any time. When you are properly diversified, it can be almost completely eliminated. But any time you own an individual stock or bet on a specific sector, the threat of experiencing an uncompensated risk is always looming. You might still benefit from compensated risk while owning an individual stock or sector, but the uncompensated risk specific to that asset could easily, unexpectedly, and unnecessarily dominate your ultimate outcome.

Don’t Get Skewered

So far, we have covered volatility risks. In the short-term it is a very real risk. In the long-run it is less concerning, but it can’t be entirely ignored. We have also broken down the drivers of volatility into compensated and uncompensated risk. Owning a single volatile tech stock does not mean you have a high expected return, because the volatility is likely dominated by its uncompensated, asset-specific risk. On the other hand, owning a diversified portfolio of stocks effectively eliminates the specific risks of any one company or sector, leaving you with compensated market risks.

Skewness is a statistical measure that shows us how outcomes are distributed relative to a normal distribution. It’s also one more reason to avoid concentrating in a small handful of stocks.

In a “normal” distribution, we’d see similar outcomes with similar magnitudes on both sides of a distribution. The classic bell curve comes to mind here.  

In the case of overall stock returns, the skew is positive rather than normal. That is, there are more negative outcomes and fewer positive outcomes … but the extreme positive outcomes are much greater in magnitude than the negative ones. Another way to describe a positive skew is a distribution with a long right tail.

As it turns out, the positive skew in stock returns is substantial. In the 2019 study Do Global Stocks Outperform US Treasury Bills? The authors looked at 61,100 global common stocks from 1990–2018. They found that the equity premium was driven by just 1.3% of the stocks in the sample from that period. Most of the rest of the firms in the sample – 61% of them – destroyed wealth over the sample period.

This should be staggering to hear. Investing in most companies resulted in negative long-term wealth creation. And even within the sample of companies that generated positive wealth, only 1.3% of them were responsible for the market’s overall positive wealth creation.

Even in a stock portfolio that is diversified enough to reduce company-specific risk, the strong positive skew remains. This creates a meaningful risk for investors who reduce their diversification relative to the total market.

Once again, diversification is the simple solution to mitigating the risk of total loss, uncompensated risk, and the positive skew in stock returns. Plus, it can be achieved cheaply and effectively with a total market index fund.

The Insidious Risk of Inflation

We have seen there is less volatility risk as we move out into longer time horizons. But that only holds true if you can handle the emotional aspect of the market’s ups and downs. Not everyone can. For the more risk-averse investor, or the investor with a shorter time horizon, adding bonds to your portfolio might make sense.

This takes us to the last, and arguably most important risk: inflation. The primary reason you invest to begin with is to facilitate future consumption. To succeed, you must generate positive real (after-inflation) returns. As such, one of the biggest risks for a long-term investor is a portfolio that feels safe, because it’s heavily weighted toward bonds, but in reality may be overexposed to substantial inflation risk.

In other words, after inflation, bonds may not provide enough returns to meet your financial goals.

From 1900–2018, global bonds delivered real geometric returns of 1.9%, while global stocks delivered real geometric returns of 5%. A 3% annualized difference over 119 years is substantial. In this respect, bonds’ lower real returns can negate their true safety over the very long-term. To the extent you can psychologically tolerate the higher volatility of stocks, there is a strong argument that bonds are riskier than stocks for the long-term investor.

To Manage Your Investment Risk, There’s Common Sense Investing

Clearly, there is risk everywhere, and it takes many forms. As you invest to meet your future consumption needs, you are faced with the risk of total loss; the uncompensated risk of individual companies, sectors, and countries; the substantial positive skew in stock returns; and the insidious long-term damage done by inflation.

Fortunately, there’s also common sense investing. All of these risks can be addressed easily with a globally diversified portfolio of low-cost index funds. To the extent you cannot tolerate volatility (due to your emotional stamina), or you should not tolerate it (due to a short-term timeline), you can reduce it by adding a measure of bonds to your portfolio. Just remember, their lower real returns call into question their safety for your long-term holdings.

What else can I answer for you about investment risks and expected rewards? Leave your comments and questions on my Common Sense Investing channel.