Don’t sell yourself short by underinvesting, writes Anita Bruinsma.Brendan McDermid/Reuters
I spend a lot of time talking to clients about how much of their investments should be in the stock market. Asset allocation – the mix of stocks, bonds and cash in your portfolio – is crucial to a financial plan.
How we talk about risk and volatility when it comes to the stock market influences how much exposure investors are willing to take on. It’s important to get the terminology right.
Risk assessment questionnaires are designed to help you figure out your asset allocation. They aim to answer the question, “how comfortable are you with risk?”
But we should not be asking ourselves how comfortable we are with risk – we should be asking how comfortable we are with volatility. These are two different concepts.
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Risk is the possibility of loss or injury. One defintion in the Merriam-Webster dictionary says it is “the chance that an investment (such as a stock or commodity) will lose value.” Most people would agree with this definition of risk.
But here’s the thing: When we look at the stock market over long time periods, what we see is that the possibility of loss has historically been zero. The stock market is actually not risky.
Over short time periods, three years or less, you can definitely lose money owning stocks. But data from every 10-year period as far back as 1949 show positive returns for Canadian stocks.
This means that as long as you stayed invested for 10 years or more, you would have made money. The U.S. stock market, as defined by the S&P 500, has delivered similar results, with the exception of a brief period during the 2000s.
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The word “volatile,” on the other hand, is defined in the Merriam-Webster dictionary as “characterized by or subject to rapid or unexpected change.” Now that sure sounds like the stock market. Stocks move around daily, and short-term stock market charts can have alarming peaks and valleys.
But when you zoom out and look at the long-term chart, the peaks and valleys flatten and the line of best fit – the line that represents the general trend of the data points – runs up and to the right. The stock market has always risen over long time periods.
Using words like “risk” has a negative connotation. When I used to ask my clients how much risk they are comfortable with, before I switched the terminology I use in these conversations, no one ever said they like risk in their investments.
They would say something like, “I understand that the stock market goes up and down.” Translation? They are okay with volatility, but they are not okay with risk.
Swapping the word “risk” with the word “volatility” clarifies conversations about investing. And when people understand that what they’re taking on is volatility, they are more likely to be comfortable investing in the stock market.
By holding a greater proportion of stocks versus bonds in your portfolio, you will increase your rate of return, which improves your chances of hitting your savings goals, especially the big one: your retirement savings goal.
It pays – literally – to get comfortable with the stock market. And getting comfortable with volatility is a lot easier than feeling good about risk. It comes with understanding what kinds of market declines you can expect, how long they last, and what a recovery looks like.
The market experience periods of big drops – like the dot-com bubble between 2000 and 2002 and the global financial crisis between 2007 and 2009 – but these are infrequent. And the recovery doesn’t take long – usually one to three years.
It’s also rare for the U.S. or Canadian stock market to have two bad years in a row. Over the 39 years since 1987, the S&P/TSX Composite index has had 27 positive years (that’s a 70 per cent hit rate) and the only time the market was negative two years in a row was in 2000 and 2001.
The S&P 500 was harder hit by the tech bubble and did experience three years of declines from 2000 to 2002, but since then declines have been limited to a single year at a time.
Understanding that the stock market is volatile, but not risky can make a big difference to your portfolio. Don’t sell yourself short by underinvesting.
Anita Bruinsma is a Toronto-based certified financial planner at Clarity Personal Finance.
