What is “risk” and why does the market go up and down so much?
“Risk” is not so much the possibility of losing an entire investment because
a company has gone bankrupt, “risk” instead refers to market volatility.
On a short term basis the market is irrational. The events of the day,
the emotions of the season move it up and down a lot. In an ordinary year
a stock can rise and fall 15% without any particularly dramatic cause.
That means that if you own a stock worth $100,000 at the beginning of the
year you can expect that at some time in the year it will be worth $115,000
and at some other time it will be $85,000. That is a huge swing and it
strains our emotional tolerance.
Risk is the emotional price we pay for the market’s superior returns.
Over roughly the last ninety years stocks have returned on average somewhere
close to 10%. That is far more than either bonds or a savings account,
which barely keep up with inflation.
A well diversified portfolio can offset market volatility. Different kinds
of stocks and bonds will move up and down at different times; while you
still get the benefit of the market’s better returns.
Commentary & FAQ
Themes
The market feels, the market thinks, the market acts. We hear these anthropomorphic terms so often that we need to stop a moment to consider just what it means to say, essentially, that the stock market is both alive and humanlike.
Several decades ago Richard Nixon declared ‘I am a Keynesian’. That was it. Mr. Republican, the arch conservative, had embraced the heresy. From that moment on everyone was a Keynesian.
Sometime between the ages of 23 and 65 nearly everyone starts to think about retirement. Everybody has a different idea of what retirement should be like. Everybody has a different opinion as to when it should happen. All, however, share one common problem – how to pay for it.
When interest rates go up bond prices go down. At first this doesn’t seem to make sense. It is the opposite of what happens with stocks; if dividends go up then generally the price does too.
Serious investment is a prosaic activity. It involves putting money aside and patiently waiting as it grows over time. The stock market, on the other hand, is the homeland of soaring financial hopes, dreams and delusions.
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FAQ
Why do I need an advisor when I can put my money into an index fund?
An index fund is a pretty crude way to construct a portfolio. Every investor wants something different from their investments. Some want income, some want growth, others like particular industries or styles of investing. All have differing levels of tolerance for risk. An investment manager can formulate a portfolio that fits the client’s precise needs. An index fund just follows the market in general.
An advisor can also encourage people to stay invested when the market is in one of its periodic bad spells. No one is immune to the emotions of the market. Most investors lose money because they become discouraged at a market bottom and sell everything. Generally they don’t come back, hence missing the opportunity that comes from long term investing. It isn’t bad stocks that lose us money, it is selling at the bottom of a bad market. A well constructed portfolio can cushion the shock of a market fall, an index fund simply reflects that fall.
What is a fee only investment advisor and how is that different from a “fee based” advisor?
A fee only advisor charges strictly on the basis of the dollar amount of assets under management. There is no incentive to buy or sell any particular stock or mutual fund in order to collect a commission. The only incentive is to grow the amount being managed. A “fee based” advisor charges both a fee calculated as a percentage of the assets under management while also collecting commissions for putting clients into mutual funds or stocks and bonds. Some advisors charge only commissions.
What is “risk” and why does the market go up and down so much?
“Risk” is not so much the possibility of losing an entire investment because a company has gone bankrupt, “risk” instead refers to market volatility. On a short term basis the market is irrational. The events of the day, the emotions of the season move it up and down a lot. In an ordinary year a stock can rise and fall 15% without any particularly dramatic cause. That means that if you own a stock worth $100,000 at the beginning of the year you can expect that at some time in the year it will be worth $115,000 and at some other time it will be $85,000. That is a huge swing and it strains our emotional tolerance.
Risk is the emotional price we pay for the market’s superior returns. Over roughly the last ninety years stocks have returned on average somewhere close to 10%. That is far more than either bonds or a savings account, which barely keep up with inflation.
A well diversified portfolio can offset market volatility. Different kinds of stocks and bonds will move up and down at different times; while you still get the benefit of the market’s better returns.