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The Consequences of Risk Taking

October 12, 2016

 

Most investors assume that the only thing that matters is whether they’re right or wrong. This is an incomplete assessment of what it takes to make money in the markets. Being right or wrong all the time is more about ego than making money.

 

Risk only matters when there are consequences attached to your actions. To understand true risk, investors need to ask themselves: “What are the consequences if I am right or wrong?”

For instance, jumping in and out of the markets for no good reason is one of the biggest reasons so many investors fail to keep pace with the market averages. I’m not saying this is impossible to pull off, but research shows the vast majority of investors would be better off sitting on their hands instead of constantly trying to time the markets.

 

Not only is market timing hard, but you incur fees, taxes and market impact costs, as well. Plus there is the psychological burden of trying to figure out when exactly to get back in or out again. Without some rules or guidelines attached to your entries and exits, this is a losing proposition.

Beyond the costs involved there can be huge consequences from your buy and sell decisions based on the way stock markets tend to trade over time. Actual returns on an annual basis are far from average based on the volatile way that stock markets move.

 

If we deconstruct the historical performance of the S&P 500 you can get a sense of why a wrong move can really cost you. Here I show the annual returns since the late-1920s, but also break them out into up and down years:

 Average gains in up years are large, as are average losses in down years. This seems obvious, but if you make a huge bet for or against the market — and you’re wrong — the consequences can be huge because large gains and losses are the rule, not the exception.

 

There is a similar return profile with foreign stocks:

 

 And things get even more hit-or-miss when you look at emerging market stocks:

 

 Another way to look at this is by understanding how often stocks rise or fall in any given year. The S&P 500 has been positive 73% of all calendar years. The MSCI EAFE has been up 70% of the time. Emerging markets, on the other hand, have been positive just 54% of the time.

And in both positive and negative years, double digit gains or losses are far more likely than single digit gains or losses.

 

When the S&P 500 has finished the year in positive territory, it’s up double digits 77% of the time. In all years it’s b