Risk Increases Over Time
Spend any time hanging out with traditional financial services salespeople or in the investment section of Barnes & Noble and you’ll no doubt hear the claim that risk declines over time.
This story is often accompanied by an “educational” piece that looks something like the sketch above. The message is that over time, the range of potential investment returns narrows toward a long-term average of about 10 percent.
In other words, when you look at the best and worst returns for the stock market for any one-year period, you could have lost over 40 percent or gained over 60 percent. That’s a really wide range.
But when you look at 20-year periods, the worst average annual performance was a gain of around 3 percent with the best being about 15 percent. That’s a much more narrow range. Over 30 years, things get even closer to the average.
The problem is real people in the real world don’t really care about percentages. We care about dollars. No matter how hard you try, you can’t pay for food, college or retirement with a bucket full of percentages.
And when we measure the same range of potential outcomes over time, only this time we do it in dollars, you get the opposite picture. The potential outcomes get wider over time.
If you happen to earn 5 percent instead of the 7 percent you planned on, it will make very little difference 12 months from now. But in 20 or 30 years, you will end up in a greatly different place.
Think of it as a cross-country flight leaving from Los Angeles and heading to Miami. If you’re a half-inch off when you take off, you will hardly notice when you fly over Las Vegas. Fail to make a course correction, however, and you run the risk of ending up in Maine instead of Miami.
It’s a wild paradox, but most of the educational stories and tools used by the investment and personal finance industry are focused on investments, not investors, and on percentages, not dollars. A study released recently came to a similar conclusion using much more detailed reasons as to why, but the message is the same. Risk actually increases over time, contrary to the expectations of the industry.
This is part of the reason that financial plans are worthless, but the process of planning is vital.
If you base your plan on earning the long-term average return of the stock market and never make course corrections, you’re at great risk of ending up someplace other than where you planned. On the other hand, if you set a course and then make slight course corrections when you find you have veered off, you can home in on your destination.
This sketch and post originally appeared in the New York Times on August 10, 2010.