Benjamin Beck, CFP®Too often, in the financial world, there's a misguided obsession with beating benchmarks like the S&P 500 within arbitrary time frames, such as the calendar year. Remember the legendary fund manager Bill Miller and his Legg Mason Value Trust fund's remarkable streak? He outperformed the S&P 500 for 15 consecutive years. Impressive, right? But here's a reality check: it was more about the quirks of the calendar than a consistent, year-round performance.
The Illusion of S&P 500 Calendar Year Returns
Even Bill Miller admitted that his success was a "fortunate accident of the calendar."
I did a little bit of research on this and discovered that in the 14th or 15th year, Miller had written to investors saying that if you're deciding to purchase this fund, we're flattered, but we believe you're setting yourself up for disappointment. Because while we've been pleased to have performed as we have, our streak of 15 years is a fortunate accident of the calendar.
What he was saying is that in each of the 15 years that he beat the S&P 500, the only time frame that he actually beat the index was in the calendar year, December to December; in each of the other 12-month periods, January to January, February to February, and so on, he did not.
What do you make of that? What should you make of that?
3 Myths About Investment Risk Tolerance
When clients talk about performance, my mind goes to the topic of risk tolerance, and how it is invariably connected to this conversation.
In the psyche of every investor is a relationship with risk. And if it were anything objective — which I don't believe it is — financial risk tolerance would have to be defined as the percentage decline in the value of someone's portfolio that they can psychologically bear. The problem is that none of the assumptions that support risk tolerance are true; it cannot be captured as a number, or in a framework, even though many financial firms try to “capture” their client’s appetite for risk using risk tolerance questionnaires.
At Beck Bode, if we allow risk tolerance to become a legitimate variable in the discussions that we have with our clients, we're setting up everybody to fail. In my view, there are several flawed assumptions that are prevalent in our industry with regard to the concept of risk tolerance.
Myth #1: That the Only Financial Risk Is A Decline In Price
The first myth is that there is only one risk, namely that risk is synonymous with percentage decline in price.
That's not true.
It’s important to be more precise: there are at least two risks: one is risk to principal, and then there's risk to purchasing power. In the act of protecting yourself against either one of these risks, either the risk to principal or the risk to purchasing power, we increase our exposure to the other.
Think about it for a second. If you construct a portfolio based on the premise that stocks are risky, you are only limiting its potential. You are, effectively, limiting its potential return. By limiting the potential for the portfolio to go down, you are also limiting its opportunity for advance. But here’s the problem with that: the more you reduce the potential return, the more you expose it to the erosion of purchasing power, aka inflation. The opposite is also true. The more you minimize the risk of losing purchasing power, the more you are exposing yourself to volatility.
The act of trying to find this middle ground between these two risks (price decline and erosion of purchasing power), is usually called balancing risk and reward. What we need to do is balance risk against risk — choosing which of the two risks that I've mentioned here are the greater long-term threat to our client and their family. Then we must move to suppress the more dangerous risk, the one that we deem more problematic, more dangerous to our client’s future. Which risk do you want to embrace? Which risk do you want to suppress?
When somebody says to me, “Oh, stocks are risky,” or, “I'm afraid of going through another 2008 and 2009,” I just ask the question, “Which risk are you trying to mitigate? Is it the temporary — however uncomfortable — declines in portfolio value? Or is it the risk of outliving your assets?
Myth #2: That There Is Such A Thing as “No Risk” in Investing
This goes without saying, but I’ll say it anyway: there is no such thing as no risk.
But when you fill out a form for your 401(k) contribution or when you invest with a firm, most firms will ask you questions like, “What investment would you be most comfortable with?” Then they give you a choice of a range of returns or declines. Basically, they are asking you how much you can stomach to “lose?”
That's the wrong question to ask.
The most important variable is not how many percentage points of decline you can handle. The most important variable is time. We've talked about this so many times that you're probably sick of hearing it from me, but roughly every five years we have a year where the markets have declined about 33% on average.
Now, to somebody who needs to withdraw a significant amount of their capital, say, two years from now, I would say that a 30% drop in the markets presents a vastly greater risk than it does to somebody with no short-term capital needs. Since the risk of holding equities declines very sharply over holding periods that are longer, if you’re planning on holding something for 15 years versus two years, then the risk of holding that portfolio declines for you. Time becomes the critical element in assessing risk, rather than a somewhat arbitrary preset percentage decline in the value of an investment.
Imagine if I asked you, “Mr. And Mrs. Jones, are you willing to hold an investment that could go down 40% in value?” How many people would say yes to that? On the surface, nobody is. But people do it all the time. They are invested and they go through a period of market decline.
It’s important to distinguish yet again between risk and volatility, two terms that often get confused and misused. To a 55-year-old couple who at minimum needs their investments to produce income for 30 years or more, a 30% decline similar to a 30% increase is an incidence of volatility, not risk.
Myth #3: That An Investor’s Risk Tolerance is Fixed Over Time
Say an investor fills out a risk tolerance questionnaire. The assumption is that the person’s risk tolerance as stated on the form, remains fixed, that it stays the same. But in reality it isn't so. That’s another misconception. We know this. Investors are emotional. We're all emotional. An investor's risk tolerance typically rises and falls based upon the scenario that they’re in, and I would say, irrationally so.
This would be bad enough if the public's appetite for risk expanded and contracted contracyclically. In other words, if people got braver when the market fell and were more cautious when it soared.
But of course, that's not the way it works.
Consciously or unconsciously, most investors’ willingness to take on risks rises with rising markets. And when the sky's falling, when the markets are going through one of those periods of decline, that's when investors are heading for the hills. Recognizing and countering this emotional ebb and flow is crucial.
If you look at the market lows of 2022, or 2008-09, you will see that the periods of liquidations for mutual funds fit almost exactly with the bottoms of the market. It's pretty crazy. But again, knowing what we know about the emotional tolerance of individual investors, not very surprising.
So at any given moment, asking an investor to assess their own risk tolerance is going to provide an unconscious and wrong — and therefore useless — answer.
A Wake-Up Call on Investment Performance: Time, Tolerance, and the Art of Surprise Avoidance
At our firm, we are committed to educating our clients about the realities of risk and time so that we can prepare them for intelligent, long-term financial decisions.
We want every one of our clients to understand that there are two forces to which they can expose their investments: volatility and the relentless erosion of inflation on their principal. And that the only really critical variable in making investment decisions is time. Once people truly understand this, then we can eliminate their surprise during periods of market decline.
Because if you don’t get surprised about something, then you won’t panic. If you don't panic about something, then you’re probably not going to sell or go to cash. And if you’re not surprised, and therefore not panicking, and you’re not selling your equity investments, you’re not going to lose out on the opportunity to gain. And if you don't lose on the opportunity to gain, you’re more likely to be able to achieve their goals.
This is the disciplined approach that ultimately leads people to realizing their vision for their financial future.
Ben Beck, CFP® is Managing Partner & Chief Investment Officer at Beck Bode, a deliberately different wealth management firm with a unique view on investing, business and life.