Do You Understand Investment Risk?

People don’t like risk.  More appropriately people do not like uncertainty.  Investment risk is about how volatile future outcomes may be, which, by any reasonable definition, is what uncertainty is about.  People are uncomfortable when the future is not specifically known, even though the tendency is for it to behave a certain way.

I came upon these charts recently. They were both prepared by Bianco Research.  They are a little out of date but the point is quite clear. We are emotionally influenced by how we see things rather than by how the thing really is.

How long term rates of return vary over time.  Based on trailing 10-year return.

200 year 10 year trailing returns

Frightening right? And it does not even have the 2008-2009 period in it.  Wow!  Who would want this?  Pay attention to the form of the graph, it is linear. The space in the graph between o% and 5% is the same size as the space between 5% and 10%.  Volatility is emphasized in a linear graph.  If I am devious and I want to convey a certain message, my choice of graphics matters.

We see that even 10 year time frames are volatile.  But what if you have a very long time frame.  Here is how the money grows over long times.


You can still see the great depression and the crash of 1987 and even 2008 but they do not dominate your impression.  This graph is logarithmic (exponential.)  It is not so exciting as the linear one, even though they are prepared from the same data.  In a log graph each step is 10 times the plateau.  1 to 10 is the same size as 10 to 100.  These graphs show the effect of compound interest more persuasively.

If we present the accumulation on a linear graph, it will be a long flat line on the bottom and explosive growth on the right side.  Not very meaningful.

For the sake of knowing something that is not really useful to you.  The average return over the period is around 9%.  A little lower in the first century, a little higher later.  Manufacturing is more profitable than farming, I suppose.

Over all a return of around 6% after inflation and about 4% more than the average for long bonds.

Over long periods of time the stock market is reasonably predictable.  It mirrors the economy as a whole and as long as people want to grow their wealth and provide for their future, it will tend to be a reasonable way to accumulate wealth.  The specific method of participating is a different question and the answer to that is more particular to the person.

The problem of course is that if you are impatient, (have short time frames) you will be more emotionally affected by investment risk than if you have very long time frames.  People are emotionally challenged by losses.  Twice as adversely affected according to Daniel Khaneman.  People cannot deal with losses without help.  My rule is, “There is such a thing as a paper profit, but all losses are real.”

So what to do?

Nassim Nicholas Taleb traded highly volatile and highly loss prone securities.  Options mostly.  The expectation was that there would be 85 losses out of every 100 transactions.  85 small losses, a few small gains and, once in a while, a gigantic gain.  A “Black Swan” in his terms.

Despite knowing with certainty how the averages would work out, the losses were difficult.  He and his team spent a great deal of time focused on other things.  Debates about anything.  Fierce debates.  Full contact Chess.  Music.  Writing.  They distracted themselves.

You can do that too.  If you have reasonable grounds for the investment in the first place, volatility can be defeated by not paying much attention to it.  If you want to be happier with your portfolio, don’t look at it so often. Even then, it might help to have someone objective who can talk you back in off the ledge.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.  |  Twitter @DonShaughnessy  |  Follow by email at moneyFYI

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