What
do we mean by risk?
When thinking about risk, resist all urges to associate
investing in the stock market with gambling at a casino. A casino has an interest in
seeing you lose your bets - that's how they make money. The stock and bond markets are not
about gambling.
The vast majority of investors buy stock in a company
because they believe in that company's future; companies that issue stock have an interest
in making sure their investors make money.
Of course it doesn't always work that way. Even the best
companies go through hard times, and their stock prices reflect that. If a stock's price
has grown at an average rate of 12% annually over a ten-year period, that doesn't mean it
earned an even 12% per year. Some years it would have done better, some worse. Some years,
it may have lost money. You might predict that on average the stock will return somewhere
around 12% per year over the next ten years. Just don't expect that exact return for any
one given year. Investment risk is measured by determining the amount that actual return
deviates from the expected rate of return.
The most commonly used measure to calculate risk is the
standard deviation. It is the "typical" deviation from the average return.
Two-thirds of the time (precisely 68%), a return will be within one standard deviation of
the average.
Consider our old friend the Standard & Poor's 500
Index. The stocks in the S&P 500 have an annual return of about 10% with a standard
deviation of about 20%. So roughly 68% of the time, results will probably fall between
-10% and +30%. The other 32% of the time, returns will fall outside this average. About
95% of all returns, however, will fall within two standard deviations. Thus, 95% of
the S&P 500's returns will likely fall within a range of -30% (10% minus 20% minus
20%) and +50% (10% plus 20% plus 20%).
Of course, that means 5% of the time (one out of 20 years),
we will have a return less than -30% or greater than +50%. For example, in 1933 the
S&P 500 reported returns of +54%, and in 1954 an impressive +53%. Conversely, in 1931,
the S&P returns were a dismal -43%, and in 1937 a nearly as dismal -35%. But no matter
how far out short-term returns get, long-term market returns generally return more or less
to the mean. Long-term, the S&P 500 has offered a pretty dependable 10% return, even
though it has gone through spectacular highs and abysmal lows in the short term.
A smaller variation around the expected result equals a
smaller standard deviation, and thus a smaller risk. This variation -- not the risk of
losing all your investment -- is what we mean when we speak about risk. Even
"safe" investments like CDs and treasury bonds have a measurable risk, since
their return does vary. As you might guess, smaller deviation is generally associated with
lower returns.
If you look at stock market returns over time, you will see
substantial deviation in the short term, with a strong upward trend over time. Market
returns are fairly constant over long periods of time, while deviations are short-term.
This is why long-term investing can greatly reduce risk.
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