The Biggest Threat to Your Portfolio (It's Not What You Think)

BlackRock CEO Larry Fink once told a story about having dinner with the manager of one of the world's largest sovereign wealth funds. The fund's objectives, the manager said, were generational. "So how do you measure performance?" Fink asked.

"Quarterly," said the manager.

Why a fund with a time horizon measured in decades, if not centuries, would care about month-to-month performance is an example of what Fink called "a dangerous preoccupation with the short term." Individual investors fall for the same trap, and it skews their perception of risk.

What is risk? Nearly every textbook and investment theory equates risk with market volatility. If a stock goes up or down more than the rest of the market, it's said to be riskier. If the stock market has a down year, people start talking about the risks of owning stocks.

But this is a weird way to think about risk, especially if you're a long-term investor. Charlie Munger, Berkshire Hathaway's (NYSE: BRK-B  ) vice chairman, describes risk like this:

"Using volatility as a measure of risk is nuts. Risk to us is (1) the risk of permanent loss of capital, or (2) the risk of inadequate return."

Risk, in other words, isn't when stocks go up and down. That's just something stocks do. Risk is when an investment goes down and can reasonably be expected to stay down forever, or when an investor fails to earn high enough returns to fund a goal like retirement.

If you're more than a decade from retirement, the biggest risk you face isn't that stocks will wobble around from time to time. It's that your long-term investment returns will be so low you won't be able to retire.

Think back to 1998. The Dow Jones plunged 20% in the middle of the year, after Russia defaulted on its debt and Asia spiraled into a financial crisis. At the time, the plunge was touted as an example of how risky stocks can be. "Investors are buying bonds because there is more perceived risk in the stock market," the Kansas City Star wrote during the fall. (Stocks actually were risky at the time because of sky-high valuations, but that's another story). 

But 15 years later, how many individual investors still care about the 20% plunge of 1998? None. No one. Few even remember it. The Dow recovered all of its losses within four months, and the world went on. What was proclaimed to be a clear example of risk was irrelevant and gone in 120 days -- a strange definition for those investing with decade-long time horizons.

This is an important topic today because stocks' recent volatility has caused investors to re-evaluate how risky they are. Millions of investors have decided they're too risky and since 2008 have plowed more than $1 trillion into bonds, which are typically less volatile. 

Time will tell how this story plays out, but odds are it will end disastrously. In an attempt to "lower risk," investors are buying bonds at record-high prices, in many cases with yields so low they are begging for negative future returns after inflation. Bonds may be one of the riskiest bets you can make today, and I don't think most investors even realize it because they're so caught up with avoiding short-term volatility. As the chief investment officer of a major bank recently pointed out, "Many investors do not understand what happens to a bond fund when rates rise." Here's the answer: You'll probably lose money. The last time interest rates were near current levels, in the 1950s, Treasury bonds lost 40% of their inflation-adjusted value over the following three decades. For retirement plans that are already woefully underfunded, a repeat would be devastating.

As you work out the choice between stocks and bonds, ask yourself more than "How much risk can I take?" Ask, "What is risk?" If you have more than a decade to invest, the extra volatility of stocks probably shouldn't scare you. Losing a permanent fortune on bonds, on the other hand -- now that is risk. 


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  • Report this Comment On January 27, 2013, at 1:24 PM, drfrank1 wrote:

    Morgan,

    Great article. I have a decent understanding of why Ameican bonds are risky in the current environment, but are emerging market bonds in a similar situation?

  • Report this Comment On January 27, 2013, at 1:47 PM, valari25 wrote:

    Your articles need to be taught in classrooms.

  • Report this Comment On January 27, 2013, at 6:53 PM, SkepikI wrote:

    Morgan: This is the best article I've read from you to date. And VERY urgent topic for me- been out of Bonds and bond funds for 6 mo, looking for the right time to return. Have not found it yet. Recent blog "B is for Bond, Buzzard, Bernanke" explains my reasoning, but the short form is I can "miss out" on 1% yields for a long time to avoid the rabbit punch from declining prices. Last 6 months, lost out on 2% while the funds I was in declined 2%. I missed out on NOTHING.

    The real question is when does the oppression of yield end? The Fed can keep this up a long time....

  • Report this Comment On January 28, 2013, at 8:32 AM, DogofYog wrote:

    Very Good article.

    One thing though, rates don't go up 5 points overnight. At the first sign of an increase by the Fed, why not rotate some/all of your holdings out of bond funds?

    My bond fund's returning 7% and my wife's at 10.6 % and I'm happy with those numbers.

  • Report this Comment On January 28, 2013, at 10:45 AM, MaxTheTerrible wrote:

    <<"Quarterly," said the manager.>>

    Given the fund objectives, I wonder if he meant quarter century... lol

  • Report this Comment On January 28, 2013, at 11:53 AM, Raphael1990 wrote:

    For someone that understands the effect interest rates have on bond prices it seems obvious that the future for holders of first class government bonds will be painful. So obvious in fact that I am a bit hesitant to believe it, but Im definitely watching closely.

    Also I think there is some value in well diversified junk bonds because people avoid them like they avoid stocks which offers savy investors a great yield to maturity for an unreasonably low price.

  • Report this Comment On January 28, 2013, at 11:55 AM, TMFMorgan wrote:

    <<Also I think there is some value in well diversified junk bonds because people avoid them like they avoid stocks>>

    A headline from last week you may be interested in: "Junk-Bond Yields Fall to Fresh All-Time Low"

    http://blogs.wsj.com/marketbeat/2013/01/23/junk-bond-yields-...

    Thanks for the comments, all.

  • Report this Comment On January 28, 2013, at 12:16 PM, Seanickson wrote:

    the biggest threat to my portfolio is if values do not revert to the mean. Although mostly invested, I have a chunk of my portfolio in cash waiting for better opportunities. However, its possible that stock valuations do not revert to the mean and I will not be able to participate in the business gains with that chunk of my portfolio and its value will be at least partially eroded by inflation.

  • Report this Comment On January 28, 2013, at 3:30 PM, SkepikI wrote:

    "One thing though, rates don't go up 5 points overnight."

    That has been historically true, but the situation we have today, yields, and high pressure oppression of rates by the Fed are unprecedented. Last I recall from an article (Morgan's I think) the Fed owned something like 17% of outstanding debt, and while no expert, I don't recall similar circumstances ever. Its very difficult for me to rely on past history when we are and have been in uncharted territory for this long.

  • Report this Comment On January 28, 2013, at 3:43 PM, TMFMorgan wrote:

    <<Last I recall from an article (Morgan's I think) the Fed owned something like 17% of outstanding debt, and while no expert, I don't recall similar circumstances ever. >>

    The Fed's share of Treasuries is actually *lower* today than it was 10 years ago. The Fed has purchased a lot of Treasuries over the last four years, but people forget that it sold most of its Treasuries in late 2008 to make room on its balance sheet to bail out Wall Street.

    http://1.bp.blogspot.com/-3H3V3-t2y64/UKvh9B7q5RI/AAAAAAAACn...

  • Report this Comment On January 28, 2013, at 4:34 PM, SkepikI wrote:

    Thanks Morgan, maybe I shouldn't be as nervous as I am if this is old hat. On the other hand, the generic idea that they sold lots at say 5% yields in 08 to buy back at 2% yield recently doesn't give me huge comfort they wont be large sellers in the future. And then there is the pressure they exerted along with FDIC? to get individual banks to bulk up reserves with Treasuries over the past two or three years? more? So what is your view of the potential for selling pressure of one kind or another to move yields much faster than we have ever seen before? Might be a very interesting article.

  • Report this Comment On January 29, 2013, at 10:52 AM, mdk0611 wrote:

    The Fed purchases oftTreasuries may not be record breaking, but what about their continuing purchases of mortgage backed securities?

  • Report this Comment On January 29, 2013, at 1:28 PM, tomd728 wrote:

    I would certainly appreciate the mutual fund wherein Mr.Yog's wife is getting over 10 %.I certainly like that number.

    I have some money in FAGIX and it is doing well considering the straight return and of course better with the re-invested "dividend" .

    Thanks mate !

  • Report this Comment On January 29, 2013, at 3:28 PM, crunkdog wrote:

    excellent article thank you

  • Report this Comment On February 02, 2013, at 8:42 AM, Peak2Trough wrote:

    Let me see if I get the argument... despite volatility being the worldwide standard in determining whether a given portfolio meets or exceeds the return of its benchmark, everyone should ignore it and instead focus on the likely return of the portfolio at a future date - that of retirement. Is that it?

    I'll go against the crowd and say that sounds remarkably imprudent to me. If one truly believed that, and you had a very long time horizon until retirement, you'd be much better of statistically by going out on the FAR end of the risk spectrum. After all, the volatility of the portfolio in the interim doesn't matter, right? It's simply the return at the end of the period that interest us.

    If that were true, we should be fully invested in unhedged futures and options strategies. They have very high volatility, but also the highest potential returns. How many of you are actually doing that?

    To me, this article feels like an attempt by the Motley Fool to gloss over the idea that many (most?) of their newsletter portfolios are not generating measurable alpha. They like to tout that the returns are higher than the S&P 500. Well, yes, they should be - Because they're taking on significantly higher volatility to achieve those higher returns.

    Volatility is important, folks. And so is choosing an appropriate benchmark for your portfolio.

  • Report this Comment On February 02, 2013, at 8:52 AM, TMFMorgan wrote:

    <<If that were true, we should be fully invested in unhedged futures and options strategies. They have very high volatility, but also the highest potential returns. How many of you are actually doing that?>>

    They also have some of the highest potential for permanent loss of capital, which, as the article points out, should be part of the true definition of risk.

  • Report this Comment On February 02, 2013, at 10:15 AM, Peak2Trough wrote:

    >> They also have some of the highest potential for permanent loss of capital, which, as the article points out, should be part of the true definition of risk.

    And individual equities don't?

    Did you not also recently write in the following article:

    http://www.fool.com/investing/general/2013/01/29/7-wild-pred...

    "1. At least one of the world's top 20 largest corporations collapses virtually overnight in the next decade (40% probability) ... "

    ?

  • Report this Comment On February 02, 2013, at 10:16 AM, Peak2Trough wrote:

    And individual equities don't?

    Did you not also recently write the following?

    http://www.fool.com/investing/general/2013/01/29/7-wild-pred...

    "1. At least one of the world's top 20 largest corporations collapses virtually overnight in the next decade (40% probability)"

  • Report this Comment On February 02, 2013, at 11:04 AM, SkepikI wrote:

    ^ A lot of what the world (and risk) looks like depends on where you sit to view it. I don't recall who said that, but its doubly true in retirement investing as opposed to "recreational investing" or investing theory. If I've exceeded my target critical mass of capital, volatility is not very threatening to me but a PERMANENT loss of capital might be if it sends me below my target. If I am under my target figure and approaching retirement all of these risks but particularly permanent capital impairment are riveting deadly threats. Under achieving wins and poor yields, "not beating the market" an annoyance, risk only in theory. Capital losses, say from declining Bond Funds, individual stock disasters....gulp... serious wounds, possibly crippling.

    30 years to retirement? Risk of permanent impairment, well, serious but not fatal. Underperformance? More than just an annoyance but time to correct it so perhaps pretty serious. Volatility? depending on your temperament and "training", or discipline anywhere from fatal to inconsequential. Allowing or predisposed to let volatility push you to buy and sell at exactly the wrong moment...near fatal.

  • Report this Comment On February 02, 2013, at 11:26 AM, TMFMorgan wrote:

    It's about the probability of permanent loss of capital. The majority (around 77%) of options expire worthless within a year. A well-diversified portfolio of equities or a broad index fund purchased at reasonable prices faces a very low probability of permanent capital loss over a sufficient time frame. Even if you purchased a basket of stocks (the re-created S&P 500) at peak prices in 1929, you made back all of your losses in real terms by 1936 (including dividends). And that was during the Great Depression!

    So, yes, if your portfolio consists of one company, you face a much higher probability of permanent loss, as my previous article argued. An index fund or diversified portfolio, much less so.

  • Report this Comment On February 02, 2013, at 12:03 PM, Peak2Trough wrote:

    >> It's about the probability of permanent loss of capital.

    Exactly! Here we completely agree. The point I'm trying to make is that that idea is not consistent with this one from the article:

    "Using volatility as a measure of risk is nuts. Risk to us is (1) the risk of permanent loss of capital, or (2) the risk of inadequate return."

    The issue is that volatility can cause both of those things.

    In any given data set where 0 is a member, higher volatility, by definition, means we have a higher chance statistically of hitting that 0, thus creating a permanent loss of capital. So again, the volatility most certainly does matter if you're concerned about a permanent loss of capital. It is fairly simple mathematics which dictates that volatility *is* risk, even as Mr. Munger defines it.

    Of course, it also means we have a higher chance of hitting a large positive number. That's what the risk / reward relationship is all about.

    >> The majority (around 77%) of options expire worthless within a year.

    That's a common misconception. According to OCC data, 60% of contracts are closed in the open market, 30% expire worthless, and 10% are exercised on a yearly basis. This varies maybe 5% from one year to the next, but is a clearly established, verifiable trend in the options clearing data.

    >> So, yes, if your portfolio consists of one company, you face a much higher probability of permanent loss, as my previous article argued. An index fund or diversified portfolio, much less so.

    Again we agree. My point is not that we should actually take exorbitant risk, that was a device I used to make my overall point that volatility definitely does matter. It is precisely volatility which gives one the opportunity for a permanent loss of capital.

    Morgan, you're a smart guy, and I enjoy reading your articles. I really don't mean to be combative with you and apologize if I'm coming off that way.

    I also have great respect for Charlie Munger, and I don't actually believe he would disagree with what I'm saying here. I don't mean to put words your collective mouths, but I suspect his and your overriding theme was to look at a longer time horizon than most are today. I agree with that.

    That said, words matter, and I think his choice of words was poor. Further, I think the reason this article struck a nerve is I do honestly feel like the one bit of important data about which the Motley Fool is frustratingly not forthcoming is the volatility inherent in its newsletter portfolios. Particularly when they use a much less volatile index (eg the S&P500) as their benchmark for returns.

    One of these days perhaps I'll work up the standard deviation for the last 10 years of Stock Advisors and prove it. Until then, I look forward to move of your articles.

    Best,

    P2T

  • Report this Comment On February 03, 2013, at 3:51 PM, ALLWIN wrote:

    Morgan, Great informative article, as per usual. What about an article directed to those who have approximately 5 -6 years to retirement, as oppose to 10 plus years?

  • Report this Comment On February 04, 2013, at 3:35 PM, LOWELLITE wrote:

    I AM IN RETIREMENT WITH 70% EQUITIES/20% BONDS/10% CASH. WHERE DOES THIS PLACE ME

    IN THIS RISK/REWARD DISCUSSION?

  • Report this Comment On February 12, 2013, at 2:45 PM, TheRealRacc wrote:

    Peak2Trough, interesting debate however your argument is flawed because you are correlating "volatility" with "chances of going broke" which are not not one in the same, no matter how many principles you try to apply to your argument.

    Because, whether we can recognize it or not, there are companies that are extremely volatile yet have an extremely low probability for reaching "$0.00" on the value scale. Just because an equity is volatile does not mean it has a greater chance of going broke. That is up to management. And management does not (normally) control the supply and demand schedules of stock shares.

  • Report this Comment On February 12, 2013, at 2:48 PM, TheRealRacc wrote:

    P2T, read your comment again and am further convinced that you cannot apply the mathematical definition of "volatility" to the "chances of permanent capital loss" when you are discussing a time-frame that includes factors that are yet unforseen and not included in a single stock's "volatility" range.

    In my eyes, volatility is a measure of impatience. BAC has been the most volatile stock on the market. Right next to it is NOK. Aren't we safe to assume that the #1 and #2 ranking stock in volatility are the #1 and #2 chances we have in the market of going broke? This is clearly not the case.

  • Report this Comment On September 19, 2013, at 2:33 PM, joebobjones1 wrote:

    Ok, but what if you DON'T have at least ten years until retirement? What if you've got 50% of your 401K tied up in the Pimco Total Return fund, and your only choice for moving it is to move it to a stock fund or fixed fund (paying 0.000000001%). What do THOSE people do? There are hundreds of thousands of us in this predicament and nobody in the investment advisory world is addressing it. Help!

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