The Consequences of Risk Taking
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 been up double digits 56% of the time. For the MSCI EAFE during positive years, it’s been up double digits 78% of the time or 54% of all years. Astonishingly, since the inception of the MSCI Emerging Markets Index, when annual returns were positive, 93% of the time they were up double digits (all but one year since 1988). Emerging market stocks have been up double digits 50% of all years.
On the flip side, when the S&P 500 has finished a calendar year in negative territory, it was down double digits 46% of the time. And in all years it’s been down double digits 13% of the time. For the MSCI EAFE during negative years, it’s been down double digits 71% of the time or 22% of all years. When EM stocks finished the year down they have been down double digits 54% of the time or 25% of all years.
Bringing it all together, here is the amount of time historically we’ve seen a double digit gain or loss in annual returns in each of these markets:
S&P 500 – 68%
MSCI EAFE – 71%
MSCI EM – 75%
So right around three-quarters of the time historically stock markets have experienced a double digit gain or loss over a calendar year.
Some investors will look at these numbers and come to the conclusion that there is ample opportunity to be a hero when investing in stocks. I look at these numbers and come to the conclusion that there is ample opportunity to make mistakes when you try to guess one way or another.
If you’re not careful, it can be easy for the market to get away from you.
By: Ben Carlson
Posted October 9, 2016