Stocks are risky but learning how to create an investment plan based on risk mitigation should help alleviate the fears.
Let’s start by differentiating between single-asset risk and market risk.
Single-asset risk is the risk of investing all your money into one asset, such as a single company, and having the risk of that company potentially going bankrupt with your investment gone and irrecoverable. This is the risk that scares many away from stocks, however single-asset risk can be diversified away. Investing in a stock means owning part of an actual company with employees, customers, assets, and goods and services. If you diversify throughout thousands of the largest companies from dozens of countries around the world, the risk you face isn’t that of permanent irrecoverable loss. Think about it. All the companies in the world aren’t going to go bust. How would you get milk, a computer, car, electricity, and everything else?
The risk you really face with a diversified portfolio of stocks is market risk — the ups and downs of the market.
On average every year or so, it is normal for the stock market to decline around 5% at some point.
On average every 2-3 years, it is normal for the stock market to decline around 10% at some point.
On average every 3-6 years, it is normal for the stock market to decline around 20% at some point.
On average every 10-20 years, it is normal for the stock market to decline around 30-50% at some point.
In a nutshell, you need to understand that you will lose money with stocks from time to time — even very large amounts. This volatility is the nature of the stock market, and it’s directly due to this volatility that you get a higher expected (or long-term average) return compared to something less volatile, like fixed-term deposits. Even when taking these declines into account, stocks have returned a compound average growth rate of 10% per annum over the last 100+ years. But you need to earn that return, and you do that by not panic-selling when the media is telling you that the next great depression or Armageddon has arrived.
For the same reason that you don’t have a permanent and complete loss of capital with a globally diversified portfolio across all markets and sectors — because that would mean there were no more companies left — these market-wide losses eventually recover and the companies continue to increase their profits just as before.
Sometimes the recovery is swift, but sometimes it can be slower, which is why you so often hear that investing in the stock market is a long term investment — because you need to have the ability (both financially and emotionally) to leave it invested for potentially 5-7 years to allow for a recovery in case of a significant fall to ensure that you remain invested to get the long term average return.
This brings us to the next problem — how can we know if we can leave it invested for 7 years, and what if we invest now and need to start drawing down on it in 7 years but there is a stock market decline in 6 years — does that mean we need 13 years??
Ok so, there are a couple of things to note.
Firstly, I’m going to assume that we’re talking about money that you will invest to draw a passive income from. What this means is that once you start drawing on it, you’re not going to draw out the whole lot. You’ll end up drawing somewhere in the neighbourhood of 3-5% per year (as a retirement income stream), which means if the market did fall, you’d only need access to a small amount of your assets and will leave most of it invested, satisfying the rule of being able to leave your stocks alone to recover.
Secondly, you should not be invested entirely in stocks. You should have some portion in safe assets such as bonds, which would give you money to draw down on during stock market declines specifically for the purpose of allowing your stocks to remain invested to recover.
So, using just what has been explained so far, let’s devise a simple plan to alleviate the basic fears of investing in these risky assets that are stocks.
Let’s say we’re planning on beginning to draw down for retirement. We might have a portfolio of 60% composed of stocks from thousands of companies around the world, and 40% in safe assets like bonds. We start drawing down 4% of our total portfolio each year and adjust that withdrawal amount up each year with inflation. If there’s no stock market drop, we can expect our stocks to go up, and we can draw down from those stocks since they have generated returns for us. So far, so good. At some point, we will face a drop in the value of our stocks since this is the nature of the stock market. To leave our stocks invested to recover before continuing to draw on them, we draw down from our bonds. Having 40% in bonds means we could quite comfortably leave our stocks alone to recover for a decade if we were unfortunate enough for it to be one of the worst falls and slowest recoveries in the past century. Most of the time, even large drops recover within 5-7 years, so this should give you a lot of risk mitigation to let the market have time to recover.
I hope this gives you a glimpse into how investing in stocks, while risky, might not be as risky as you imagined it to be, and that if you design a portfolio around risk mitigation, you can reduce or eliminate the chance of any single risk being catastrophic.
The rest of this site will continue to explain what stocks and bonds are and how to choose proportions between them and within them to match your own personal risk profile.