How Your Risk Avoidance Is Killing Your Portfolio
I remember being 7 or 8 years old when I first rode a roller coaster. It was a wooden, rickety ol’ bastard that seated 4 people in a car. It was blue, didn’t really go up that high, and had no loops, no hardcore turns, and no fear-inducing name like “The Cobra” or “The Whiplash”. In fact, it was a pretty standard roller coaster. As I was encouraged by my family to give it a try, I got in line (contrary to what my bowels and better sense were trying to tell me at the time), and found myself on the coaster. Once I heard the fateful click of the seat belts, in which I had less confidence than would a origami swan against Mayweather, I knew I had fucked up. Up we went, down we fell, around the turns we went, and by the end of it, I came to a realization about my own personal risk avoidance:
I was fucking right to be scared. I hate roller coasters.
And that was the first time that I felt justified in my risk avoidance. After all, the experience was about as pleasant as trying to drink sand. What’s funny is, at no point was I in any real danger. Of course, any quick Google search will show you that roller coasters are not 100% safe, but the chances of you getting hurt on a roller coaster are less than a Korean-speaking martian coming down and cooking you a 9 course Ukrainian dinner (pierogies and all).
This story sheds light on something that seems to be pretty typical of millennials: we’re really not about taking a ton of financial risks. After all, we went through middle school and high school listening to our parents/aunts/uncles/grandparents/teachers tell us about how they were more screwed than a sushi bar in New Mexico. So of course we’re not about financial risks; that recency bias is still reverberating through our subconscious.
However, dear millennials, I’m here to tell you today that risk avoidance can really harm you in the long run, especially if you’re not careful about what risks you should be taking, and which ones you shouldn’t. Today, I’m going to throw some math at you, and show you why you really can’t afford to NOT take financial risks.
First, a word about averages…
Yes, we all know that an average is used to try to make some sense of the “middle” of a dataset. A very common question asked is, “How much return can I expect from the stock market?” Well, it really depends on a few things…
- What period are you using? After all, I might get a very different average if I start at 2000 than if I start in 1974. Because averages are susceptible to outliers, we need to make sure we’re not including an unfair amount of them in our dataset.
- What average are you using? Is an arithmetic average the right one to use? Should you be using a geometric one instead? In general, geometric averages are more standard when measuring stock market returns, but I’ve seen some scary arithmetic averages on the interweb that are flat-out WRONG…
- Is that even the right measure? After all, a median is generally accepted as a better measure of central tendency than an average, so why do we constantly use it? I don’t even know folks.
So for our risk avoidance argument today, we’re going to say that the stock market returns around 9% per year. Some of you may agree, some of you may disagree, some of you may argue inflation, some of you may give me the Trump argument, some of you might say that’s only the U.S. stock market, blah blah blah…
The 9% is only to illustrate an example. So if you’re panties are all twisted up, excuse yourself, head over to the bathroom, do yo’ bidness, and chill.
Where do we find more risk in the stock market?
Simply put, you’re going to find more risk in smaller companies than you are in larger companies. This makes sense on a number of levels. First, who do you think is more likely to go bankrupt: ExxonMobil or RinkyDinkPaloAltoStartup, Inc.? Right. Bigger companies (in terms of market capitalization) tend to be longer established, better positioned, and have WAY more cash on hand than the baby companies. Second, who’s running these companies? Can you imagine some 65 year-old executive running the “Uber-but-for-sushi” company? NO! It’s going to be some kid from Stanford/NYU/UT/Berkeley. Third, think about competition. Is it easier to compete against Wal-Mart or some wine delivery service? Exactly.
So now we know that bigger companies come with less risk, and smaller companies come with more. And just in case you forgot your freshman economics course, is there such a thing as a free lunch?
Not really No. So, because they contain more risk, they’re going to have a higher return than larger companies.
So, if we’re to follow the logic, risk avoidance really translates into RETURN avoidance. Essentially, you give up returns when you reduce risk.
The difference 1% makes
Here’s a quick example that can show you what a 1% difference in returns can do to your portfolio.
Let’s take the average salary in the U.S. ($55,000), and assume that this average Joe/Jane invests 10% per year. He/she does this for 30 years, and gets a return of 9% per year. Class, what’s our final number?
$817,163.69. Very good, class.
Now, what if Joe/Jane reads this article and decides to add a little bit of risk to his/her portfolio? A return of 10%, as opposed to 9%, over the course of that time means that instead of $817,163.69, they end up with…
$995,188.84. Just under $180,000 more.
So, Joe/Jane’s risk avoidance is costing them almost $200,000 in assets over the course of their working years.
But again, this is just an example. What does the real data say?…
If you’re not an avid reader of The Motley Fool, I highly suggest you look into their site. They’ve got some great pieces of advice, and have been around forever. So when I wanted to find out how much more small stocks return than large ones, I found this from their website:
Now, this data was pulled from 1926-2006, so keep in mind asset prices in general were overpriced towards 2006. BUT, look at how much more return you get with the smallest 10% of stocks than with the 10% largest of stocks? If we put that 14% into our calculations, we get:
$2,237,053.53. By increasing our risk, and our returns, significantly, we almost triple the amount we would make over 30 years.
What does this all mean?
This means that your risk avoidance can really cost you, especially in the long-term. It means that even a small increase in returns can mean a big difference for what you earn over the course of your investing career. However…
What this DOESN’T mean
Not everything is super rosy up to this point. There are certain things you have to keep in mind:
- This is not for anyone about to retire in the next 10 years. This is a blog for millennials, so if your son/daughter/nephew/niece/grandson/granddaughter is showing you this, and you’re thinking it’s a good idea, stop reading now. This technique only applies to those who have 20+ years of investing ahead of them. Not you, grandma jones. You’re still VERY MUCH entitled to your risk avoidance state of mind.
- You can have great returns, but you will pay for it. One thing I didn’t talk about was the standard deviation column above. What that means, if you remember your bell curve from statistics, is that for the 10th decile, there is a 68% chance of your stock returns being somewhere between +60% and -30%. Can you imagine losing 30% of your portfolio over the course of a year? That’s enough to get most investors shaking in their boots.
- You should take as much risk as you possibly can. There are different kinds of risk out there, and I’m not saying you should pile it on for the sake of piling it on. What you should do is make sure that you’re taking the appropriate amount for your situation. Diversification is still a thing, people.
OK, but how possible is this, really?
Is it possible to really buy the smallest 10% of companies? I mean, it’s not as simple as just downloading a file with market caps, chopping off the top 90%, and then buying what’s left. We’d need millions of dollars and a shit ton of time on our hands to even bother with that. Not to mention that the trading fees would more than likely be astronomical. So, what’s a lonely retail investor to do?
We’re to buy index funds, sparky. That’s what we’re to do.
So, I decided to do a bit of searching, and here’s what I found about most small-cap index funds:
- You can find specialized ones, but you’re going to pay. If you’ve read up on index funds before, than you should know that one of the main benefits is that they’re not expensive to hold; their fees are generally under 0.25%. However, if you want something a little different (like an actively managed fund or fund that tracks a weird index), you’re looking at paying at least .80% as your expense ratio. No good.
- Most track the Russell 2000 index. The Russell 2000 index contains the 2000 smallest companies out of the Russell 3000 index. That might make you think, “Well damn, that’s 67% of the companies, not the 10% like the example above.” However, the Russell 2000 companies only account for 8% of the total market cap of the Russell 3000. Basically, they’re small enough to get done what you want done.
So yes. You really can get these kinds of returns, if you’re willing to put your risk avoidance to the side and “take the plunge”, so to speak.
How Your Risk Avoidance is Killing Your Portfolio – The Wrap Up
Risk avoidance is a key part of human nature. It’s why we’re wary of strangers, why we tend to smell food before we eat it, and have a natural inclination against heights. But when it comes down to your investment portfolio, your risk avoidance might actually be doing you more harm than good over the long-term. Things to keep in mind:
- 1% can make all the difference. $200,00 difference. ’nuff said.
- You’ve got to do what’s best for you. Which means you’ve got the take the risks that make sense.
- This is actually possible. Find a fund that’s cheap, and tracks the Russell 2000 index. You don’t need something that tracks the 17 smallest companies in Singapore. Trust me.
Now you’re up. What sort of risks do you have in your portfolio? Have they paid off? Have you had some pretty big swings in your portfolio, and if so, how did they make you feel? Do you like roller coasters? 😉 Comment below!
For more from The Code To Riches, check out:
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- How Much Is Half A Million Dollars?
- The 10 Best Finance Books Money Can Buy
- 9 Credit Score Hacks You Must Know
- Why I Never Want To Retire
- The Laziest Way to Riches – Investing In Index Funds
- Budgeting Basics – Allocating $$$ Like A Boss
- Fuck You, Frugality
- Why A Million Budgeting Tips Will Never Be Enough
Keep trying to crack the code,
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