This book is not primarily about the "why" of investing, but about the "how." Our principal topic is the process of putting your savings and investment flow to work to earn the best return possible at an acceptable level of risk. In that context, this chapter and Chapter 2 are big picture chapters. In these two chapters, I am concerned not just with the risks of losing money on a specific investment, but with the risks of failing to meet a specific investment objective-the risk of being unable to cover a specific future need or obligation. More generally, I am concerned with investment choice-the task of selecting effectively and efficiently from a large menu of investment offerings to implement an investment plan. To understand the significance and interaction of risks and investment choices adequately, it is useful to look broadly at risks and investment returns-and at the reasons for saving and investing. Joe, the astute investor mentioned in the Introduction, found these chapters helpful in developing a perspective on his investment program and the motivation to create a plan.
The founders of political economy-the eighteenth- and nineteenth-century name for economics-felt they needed to explain the motivations behind saving and investment. Some of their explanations were relatively complex and, even by today's standards, sophisticated. An important element in nearly all of their explanations for saving was the idea of putting something aside today to finance future consumption.
We save and invest to cover our future needs and obligations. Most savers and investors have relatively clear objectives. These are often formal and specific: to accumulate enough money to buy a new car without borrowing, to pay for children's education, or to provide for a variety of lifestyle choices when the saver/investors reduce their participation in the workforce.
In this chapter, I offer an eclectic personal perspective on some of the financial planning and investment implementation issues that every investor must deal with. My perspective reflects my perception that many investors embark upon investment choices without understanding what is possible and what is not, and without understanding the magnitude and nature of some kinds of risk. Of course, the essence of risk is that it makes outcomes uncertain.
Most investors who buy a book about selecting mutual funds and exchange-traded funds have very specific expectations. I intend to meet those expectations fully. However, to put the fund selection objective in focus, I will devote a few pages to discussing some aspects of wealth management-investment planning, risk evaluation, and risk management-that are often overlooked. One purpose of what may seem a digression to some readers is to amplify the Introduction's demonstration of the importance of improving an investor's fund selection by even a small margin. If your plan is clear and you appreciate the importance of small performance improvements, do not hesitate to scan the section headings and exhibits in the balance of this chapter and in Chapter 2. If nothing in between grabs your attention, go on to Chapter 3.
A Life-Cycle Approach to Investment Planning
Many of the people and organizations that offer investment advice to individual investors emphasize the importance of taking a long-term-even a life-cycle-approach to financial planning and investing. These recommendations are certainly appropriate, but the way they are often stated fails to consider some important realities that affect an investor's ability to implement the advice.
A young family unit typically has relatively few liquid assets to invest. The principals are paying off student loans, incurring mortgage debt, and spending most of their income (which does not yet reflect their peak earning capabilities) on goods and services. Any inheritances from their parents' generation usually lie in the future, and retirement and college tuition bills for their children seem years off, relative to the resources the young family can commit immediately to a saving and investment program. The adults in such families should certainly begin to learn about financial planning and investments. But it is not realistic to expect a young family to cut back sharply on current consumption to increase their savings rate or to adopt a sophisticated portfolio management process to handle a small portfolio. Subject to some minor qualifications, young adults should invest as much as they can in various tax-sheltered retirement funds, such as 401(k)s, 403(b)s, and individual retirement accounts (IRAs). Their initial portfolios should probably be relatively aggressive. Their human capital will be largely converted to financial assets in their remaining years in the workforce. Most investors do not have enough financial assets before age 45 to worry excessively about asset allocation or aggregate portfolio risk. Nonetheless, the example of Joe and Pete in the Introduction demonstrates the importance of starting early and earning a good return to take advantage of the power of compounding returns.
By the time the earning members of the household reach their high earning and asset accumulation years-typically mid-forties through mid-sixties-financial planning should become a high priority. Commitments and requirements for family education expenses, lifestyle choices, and retirement objectives should become clearer during that period.
One of the secondary objectives of this book is to help readers reach appropriate "make-or-buy" decisions at various stages in the financial planning and implementation process. In this case, "make-or-buy" means-at the extremes-do-it-yourself or pay one or more advisers to do the work for you. Most individuals who like the idea of understanding and controlling every aspect of their financial lives can certainly learn enough to do an adequate job of basic personal financial planning and they can implement the plan in an intelligent way. However, a full understanding of all possibilities and pitfalls is beyond the scope of most do-it-yourself efforts. The greatest mistake most investors make is failing to obtain necessary information and advice from professional advisers. The second greatest mistake is to accept bad advice. You cannot count on avoiding either of these mistakes if you do not have some personal understanding of investment and financial planning principles.
A financially sophisticated individual can certainly take on most aspects of a financial plan and its implementation. In general, the quality of the result the individual achieves will be, at least in part, a function of the time and effort committed to the process. Not every intelligent and financially sophisticated person will be prepared to make the commitment necessary for a total do-it-yourself approach. In fact, the more sophisticated do-it-yourselfers are, the more likely they will recognize what they do not know. A discussion with a tax planner or investment manager who has a complementary skill set to your own will help ensure that major issues have not been overlooked.
At several points in later chapters, the need to monitor your investment portfolio will become apparent. Hiring a planner or other adviser is not a substitute for watching your own nest egg. For most family breadwinners who have reached the age of 60, their investment portfolio and vested benefits will affect their living standard for the remainder of their lives far more than current or future employment income. The time they devote to their portfolio rarely reflects this fact.
The Trade-Off between Risk and Reward Works Only within Limits
One of the axioms of a beginning course in finance is quickly understood by virtually every student: Within the range of investment choices where most investors operate, an investor can usually expect a higher return for a given period in exchange for willingness to accept a somewhat greater risk. This relationship and the range of probable return variations are illustrated in Exhibit 1.1.
Historic data on performance of various categories of investments can give an indication of the nature of the risk/return trade-off, but it is the essence of risk that future returns cannot be known in advance. For a specific period or for a sequence of periods, the effect of accepting greater risk will be greater dispersion in returns. The cumulative return for a risky investment policy over a long period may be higher or lower than the return from a lower-risk investment.
The fact that a specific outcome is not favorable does not invalidate the general association of higher risks with higher returns. An unfavorable outcome does highlight several important effects of risk on long-term results. First, the result of a sequence of risk/return choices may give results that are substantially better or worse than the investor anticipated at the time each of the choices was made. Second, a principal characteristic of risk is that it increases the range of possible returns on both the upside and the downside. The range of return variations over a 5th to 95th percentile range illustrated in Exhibit 1.1 is wide even for a single period as risk increases. A single high-risk investment, particularly if taken on a leveraged basis, can wipe out an investor's financial assets. It may be impossible to play again in a subsequent period. The dramatic effect of high-risk investment on cumulative returns is best illustrated by the effect of risk (volatility of return) on the compound return expected from a portfolio in Exhibit 1.2.
The graph of results expected from compounding 12 percent and 20 percent arithmetic or simple returns at various standard deviation (risk or volatility) levels illustrates the possible effect of return volatility on long-term investment results.
Annual volatility in the range of 30 to 50 percent has been common in recent years for some undiversified equity investments. When volatility gets this high, the risk increases that substantial losses cannot be recouped even in the long run. As the right-hand side of the graph shows, the compound expected return at high levels of volatility drops sharply. The 20 percent average return provides a compound expected return of about 12 percent at a 50 percent volatility level and the 12 percent average return gives a compound expected return of less than 3 percent at a 50 percent volatility level. Volatilities of individual stocks and portfolios of stocks with similar risk characteristics often measure over 50 percent. The technology-stock-heavy Nasdaq-100 index and the QQQQ exchange-traded fund (ETF) based on it traded at 50 percent volatility levels for long stretches around the turn of the millennium. At a given average return, this high risk level reduces longer-term expected returns. The risk is greatest with single stocks or baskets of highly correlated stocks like the portfolio of the QQQQs. A catastrophic loss can nearly eliminate the chance to recover in the long run.
The point of this graph is that at a reasonable average return, leverage and volatility can reduce the compound return to the vanishing point. This graph is based on the return pattern of an equity portfolio. Single stocks, like some of the dot-coms, had recorded volatilities off the right side of the graph in the run-up to the peak of the technology bubble in 2000-and in the subsequent run-down. The prices of some of these stocks dropped so far that recovery was/is hard to imagine. Simple tools to measure diversification-and, hence, the concentration of risk-can improve long-term return expectations and reduce risk.
Most of the risks reflected in the risk/return trade-offs illustrated in Exhibits 1.1 and 1.2 and the most common types of risks examined and evaluated by investors are market risks. There are, however, a number of risks that are best examined and evaluated outside the relatively simple framework of securities market risks.
Thinking About the Big Risks
In the early years of the twenty-first century, most American investors take comfort in the relative stability that the U.S. economic system has enjoyed since the Great Depression of the 1930s. The United States has been an example of a stable social environment for an even longer period, dating back at least to the end of the Civil War in the 1860s. The absence of foreign armies in the settled portions of the United States since Revolutionary War times supports the belief that direct involvement in armed conflict is improbable for most U.S. citizens. Events since September 11, 2001, have shaken public confidence, but most Americans view risk in a very different way from investors who live in many other countries.
Citizens of Western Europe have seen their immediate environment in turmoil as recently as World War II. Citizens of the Middle East, Eastern Europe, Asia, and many parts of Africa have witnessed great social, political, and economic changes and military activity even more recently. On a global basis, the American experience of long-term political and economic stability is almost unique. Only in Britain and the United States have securities markets operated relatively continuously since the end of the eighteenth century, and even the London and New York markets closed for several months during World War I (Brown, Goetzmann, and Ross 1995).
Addressing the global fragility of social stability and financial continuity is not to suggest that buying a mountain cabin and stocking it with several years' supply of freeze-dried food and some heavy weaponry is an appropriate part of any American's retirement strategy. However, anyone making a financial plan should consider the possibility of major structural change in the social and economic environment that will affect the value of investments and the range of lifestyle choices available. On a historical, global basis, these changes have been more frequent and more profound than the North American experience implies.
Most financial plans do not look beyond normal market risk-a level of return volatility substantially less than that experienced in the United States in the 1930s or around the turn of the millennium. Little or no attention is paid to hard-to-anticipate systemic risks-risks that the economic system could have a very different appearance and function in the time period that is relevant to an adult with a remaining life of 50 years or more.
During the cold war, military planners had a phrase for such hard-to-anticipate risks. They called them "unk unk" risks, short for unknown unknown risks. It is impossible to know what you do not know that should worry you, especially over a long time horizon. There are, of course, some major known risks that can be appraised. Looking at known risks will sometimes provide a degree of perspective on systemic risks and unk unk risks. Among the known risks are the risks of inflation and of extreme longevity and the peculiar risk of relying on what is sometimes called "time diversification" to help a risky investment policy meet retirement savings objectives. So-called fat-tailed risks even challenge the analytical framework typically used to evaluate risk.
Exhibit 1.3 shows the average annual rate of inflation by decade in the United States from World War I through the more recent period of relatively modest inflation.
Overall, the United States has a good record of controlling inflation. By way of contrast, Exhibit 1.4 and Exhibit 1.5 show two examples of hyperinflation from the twentieth century.
During the Weimar Republic hyperinflation in Germany (1920-1923), the value of the reichsmark declined by a factor of 100 billion to 1 relative to the British pound. By the end of this episode, the money needed to buy a sausage weighed more than a dozen hogs. More recently, Brazil experienced inflation rates averaging more than 25 percent per month from 1988 through 1994.
Excerpted from Someone Will Make Money on Your Funds-Why Not You by Gary L. Gastineau Excerpted by permission.
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