Transcription
Welcome back! In today's video, we're going to investigate the question of risk tolerance and why it's crucial to approach answering this question correctly. Many people tend to make mistakes with this question and provide an incorrect answer, which can hinder the growth of their investments.
When we hear the word "risk," we often associate it with the possibility of losing all of our money in some risky investment. Consequently, when we are asked about our risk tolerance—whether when setting up a 401k at work or in meetings with a financial advisor—we tend to have a skewed understanding of the concept. Some advisors even use outdated methods, like the 100 minus your age rule, to determine the percentage of stocks you should have or rely on silly questionnaires that oversimplify the process.
These approaches pose numerous problems that we need to address so that people can make a more informed decision and stop sabotaging their investments. This video will help you make better decisions based on factual information and studies, enabling you to make an informed choice for long-term financial success. Ultimately, your goal is to maximize returns while considering the associated stress that comes with investing.
I hope you hit the like button, and if you haven't subscribed to the channel, please consider doing so. Okay, let's get started!
To understand the importance of the risk tolerance question in determining asset allocation, let's examine how different assets have performed over time. Let's begin with a 10-year period ending June 30th, 2023. These were unmanaged indexes and thus not subject to fees like mutual funds. According to Blackrock, the annualized returns of U.S. equities—which just means U.S. stocks—was 12.8 percent, making them the top performer.
Global infrastructure stocks followed with a 6.7 percent return. Bonds made an appearance, ranking sixth with a 3.5 percent return, but that was for high-yield bonds, also known as junk bonds or non-investment grade bonds. These bonds offer higher yields but come with a greater risk of default. Clearly, U.S. stocks have really dominated by a wide margin during the past 10 years.
If you see cash on this list, it's referring to the Bloomberg's Barclays U.S. Treasury Bill Index. For REITs, coming in at 4.9 percent, the S&P Global Real Estate Investment Trust Index was used. For the past 10 years, again ending in June 30th, 2023, we could also just compare the Vanguard Total Stock Market Index (VTI) and the Vanguard Total Bond Market Index (BND). Here, stocks returned around 12.29 percent while bonds yielded 1.49 percent.
Over the past 30 years, the Total Stock Market Index has averaged around 9.92 percent, and the Total Bond Index averaged around 4.21 percent. Now, let's consider a really long-term study done by Vanguard comparing bonds and stocks from 1926 to 2019. Bonds have averaged 5.33 percent, and stocks have averaged 10.29 percent.
Now, bonds are considered less volatile than stocks, and that's why they are considered less risky. But shouldn't we still acknowledge that investing in an underperforming asset over time can also be risky to our financial goals? Plus, it certainly doesn't mean that bonds can't go down in value. For example, in 2022, both the Vanguard Total Bond Index and the U.S. Aggregate Bond ETF experienced drops of over 13 percent.
But just to be fair in comparison, the S&P 500 was down slightly over 18 percent in 2022. When we analyze the U.S. Aggregate Bond Index from 2004 to 2022, we find that it had only three negative years, with 2022 kind of being an anomaly. On the other hand, the S&P 500 also experienced only three negative years as well but suffered a decline of around 37 percent in 2008, which can be emotionally challenging in the short term.
When it comes to long-term investment growth, these examples illustrate the massive disparities between stocks and bonds. Let's just look at the 30-year Total Stock Market Index return of 9.92 percent compared to the Total Bond Index of 4.21 percent. Using just a $100,000 portfolio invested over the past 30 years, a 100 percent stock index would have grown into about 1.7 million dollars, but a 100 percent bond index would have only grown into about 344,000 dollars.
What if somebody had a 60/40 portfolio, that many advisors recommend, that is, 60 percent stocks and 40 percent bonds? That 60/40 portfolio, rebalanced at the beginning of each year, would have grown into just a little over one million dollars. But that's still a loss of about 690,000 dollars compared to all stocks.
These numbers highlight the potential of long-term growth that stocks offer compared to bonds. When investing, we should always consider it a long-term endeavor. Money that we may need for immediate expenses should not be invested in something that can go down in value. However, when investing for our future, we need to balance short-term stress with long-term performance.
Stocks have historically outperformed bonds over the long term. Although including bonds in our portfolios may reduce short-term volatility, it also damages long-term performance, especially when it comes to investing in our portfolios. High risk just simply means having a higher percentage of stocks compared to other assets such as bonds or REITs.
However, what many people overlook are the truly high-risk mistakes they may be making. For example, having their entire retirement fund invested in their employer's company stock is extremely risky. You don't want all of your 401k invested into a single stock—that's risky. In one of the worst cases in history, we have the infamous Enron company, where thousands of employees lost over a billion dollars in retirement funds.
Likewise, anytime we are investing in individual stocks, that exposes you to much more risk compared to investing in a broad index. And then, of course, if we are paying unnecessary management fees, it increases the potential for underperformance. These are easy things we can correct to lower our risk and have better returns.
Another aspect that people often overlook is that there are very few investments without risk. Even investments that many consider safe, like real estate and gold, have experienced significant drops in value in the past. Real estate crashed in 2008, gold dropped around 28 percent in 2013, and around 22 percent in 1997.
Remember, as long as we are talking about broad indexes for bonds, gold, real estate, or stocks, risk here is just referring to more volatility. Riskier investments, such as stocks, come with more volatility, but they also have offered better long-term performance. As investors, we really shouldn't care what things do in any given year.
Many people tend to err on the side of being too conservative because they misunderstand what it means to take higher risks. The simple fact is that risk is necessary. Consider this: if you think the safest thing to do with your money is keep it in a lockbox under your mattress or in a sock drawer, you are guaranteed to lose money due to inflation.
While options like CDs, money market accounts, and savings accounts provide short-term protection, they usually don't yield good long-term returns and may even struggle to keep up with inflation. They are typically used for short-term investments to cover immediate expenses within the next few years.
For example, during the housing crisis of 2008, it took approximately five years for the market to fully recover. Therefore, we don't want to invest in stocks that we don't have the time to ride out during periods of volatility. I understand that advisors often oversimplify investment decisions into cookie-cutter approaches, as if we're ordering from a menu.
They might not have the time to fully explain all of the details of investing. The problem is that when presented with oversimplified graphs and terms like low risk, moderate risk, and high risk, most people don't fully understand the consequences of wanting to be safer with their money. They think, "Oh, I don't want to lose all my money, so I better stay away from high risk." But that's not what it means at all, and many people end up making poor choices because of it.
Furthermore, very few people can accurately answer this question anyway. Just because someone can handle risk in other areas of their life, like bungee jumping or other real-seeking adventures, doesn't mean that they can easily tolerate seeing their investments go down in value. Predicting how one will feel during a bad market downturn is nearly impossible if they haven't experienced it before.
Plus, younger investors or those who started investing after 2008 haven't truly experienced a significant market decline. I know the stock market was down around 18 percent in 2022, but the S&P 500 has averaged a compounded annual growth rate of 13.26 percent for the four-year period ending in 2022. That's remarkable, and everyone should be happy with that.
A bad market refers to situations like in the early 2000s and the housing crisis of 2008. Imagine the year 2008 when the market dropped around 37 percent in one year. That can really be an emotional rollercoaster for some people. For instance, if someone had a million dollars in their retirement account, they would have seen a drop of 370,000 dollars during that year alone.
Predicting how you'll react and feel during such periods is extremely challenging, especially considering that emotions can differ greatly between somebody in their 40s and maybe somebody in their 60s. However, for younger investors who don't need immediate access to their money, these downturns present opportunities since they can continue investing consistently and buy when the market is on sale.
After all, we like buying clothes and other things when they're on sale, so why shouldn't we feel the same about stocks? But these emotional periods can lead some people to make major mistakes by selling when the market is down. In the past 10 years, ending in 2022, the S&P 500 returned a compounded annual growth rate of 12.6 percent, which is great, but that's only for those who stayed invested throughout the entire period.
Even if we include the financial crisis of 2008 and examine the 20-year period ending in 2022, the S&P 500 had a compounded annual growth rate of 9.8 percent. Again, this is only true for those who didn't panic and sell during stressful times. Averages only reflect the performance of investors who stay the course and remain fully invested during both the good and challenging times.
So what should we do? First, we need to realize that seeking more safety has translated into lower returns over the long run. Furthermore, if we have a long-term view, decreasing our risk or desiring more safety will likely result in worse returns. We shouldn't rely on outdated cookie-cutter rules like 100 minus your age or any oversimplified approach.
Even Vanguard's target date funds aim to be more aggressive in their approach. These funds readjust the stock-bond ratio as you approach retirement. As I record this video, for example, the 2035 fund, designed for individuals looking to retire in 2035 or just a little over 10 years from now, currently has around 71 percent stocks, including U.S. and international stocks, and only 29 percent bonds.
The 2045 fund, aimed at individuals retiring approximately 20 years from now, currently holds around 86 percent stocks and only 14 percent bonds. The 2055 fund, meant for someone retiring in about 30 years, has about 90 percent stocks and less than 10 percent bonds.
What about Vanguard's index funds for people already in retirement, like the 2020 fund? Their target retirement 2020 fund still holds around 42 percent stocks, including U.S. and international stocks. Vanguard understands that regardless of our age, we need a higher percentage of stocks in our portfolio than most people tend to choose; otherwise, we might be disappointed with our returns.
Personally, for my own investments, I would carry an even higher percentage of stocks at any point in my life than all of these target date funds. Any money I know I won't need within five years is always in stocks. If you aim to maximize your long-term returns, it's important to push your risk tolerance and have a higher percentage of stocks that can still align with your emotions.
But emotional discipline is crucial to look past the short-term volatility and ensure you have time and the discipline to ride out any market downturn. Your goals, time frame, financial situation, and feelings about risk will be key factors in deciding how to allocate your investments between stocks, bonds, and short-term investments.
The ability to stick with your plan through market ups and downs is vital since staying invested over many years is almost always preferable to the alternative, which is letting time pass without being in the market because of panic-induced selling. As Warren Buffett once said, "It's an easy game if you can control your emotions."
However, some people overestimate their ability to handle the stress they may experience in a bad market. During such times, emotions may take over, leading to poor decisions. Therefore, it's important not to deceive yourself about your capacity to withstand market turbulence and remain fully invested during challenging times.
Keep in mind that a higher percentage of stocks in your portfolio increases the probability of better long-term returns. Remember that when referring to portfolios, more risk just translates into a higher percentage of stocks. That has been a good thing over the long term.
Whatever you choose, the key is to understand what you own, where the potential short-term downside is, and your own tolerance for short-term pain so you don't succumb to the pressure of switching strategies or giving up in the face of unpleasant but completely normal market downturns.
I hope this video has given you some things to consider. Please leave your comments below; I'd like to hear about what ratio of stocks to bonds you prefer. Thank you for watching!