15 Jun Risk: The Final Frontier

We tend to pay an awful lot of attention to investment returns. Mostly, I suppose, because they are in our faces all the time. Turn on the television, listen to the radio, pick-up the newspaper; even our smart phones have applications to keep us continuously abreast of the latest valuation placed by Wall Street traders on a basket of thirty stocks we know as the Dow Jones Industrial Average (DJIA). But what does today’s valuation have to do with our lives, and should it make or break our day?

Well, probably not and most of us will agree that wherever financial market are today is meaningless to the long-term investor. Still, today’s valuations have everything to do with the ‘rate of return’ measurement on our brokerage statements by which most folk tend to measure their success or progress.  Are those rates-of-return truly meaningful and important?  Maybe not.

If we can agree that very short-term changes in valuation are unimportant to our long-term success, by extension, so too are the short-term ‘rate of return’ calculations they generate. But what about rates of return over, say five-year periods? Well, let’s take a couple, and use the broader S&P 500 index of five hundred stocks to represent the stock market.

From 1997 – 2002 that index’s annualrate of return was +8.3%. The annual return on the very next five years (1998 – 2003) was -3.8%. If we have or expect to have a twenty- or thirty-year investing experience, does the number that shows up for either five-year period mean anything to us? Has our success in investing gone from rosy in 2002 to dismal in 2003?  Or, from dismal in 2013 (-0.1% ROR from 2008 – 2013) to glorious in 2009 (+15.1% ROR from 2009 – 2014)?

More importantly, what can we do about it? Nothing. Returns are driven by forces beyond our control, and trying to guess when to get into and out of the market is a fool’s errand. So, rates of return for any specific period really do not mean a whole lot to us and there is nothing we can do about them anyway. But if we can’t control returns, what can we control? Risk.

We all understand the relationship between risk and return. And we can measure with some degree of statistical accuracy the probable risk (measured in Standard Deviations of volatility) of any single or combination of investments within or comprising our portfolios. We can also project with at least some level of accuracy the average rate of return over many decades we might expect from such an investment or portfolio (given a set rate of inflation) and the probability of our plan for the use of that portfolio succeeding.

Armed with various portfolio configurations and the statistical probability for each of them successfully meeting our objectives, we can select what appears to be the best configuration from which to develop our investment strategy.  And, we can perform this analysis annually with updated portfolio values and reaffirmed or modified objectives to ensure that our configuration remains optimal based upon the foregoing assumptions.

Like tenth-century mariners peering over the edge of a flat Earth, the masses watch the ticker tape, oblivious to any measurement of risk and its implications for the long-term success of their financial plans. Risk is that Final Frontier pioneers explore in search of new opportunities. It is this frontier upon which we should all be focused. That is where we can take control and make a difference in our financial lives. That is where the Conservatory sets its sights for its members.