Volatility is the biggest risk investors face: Fisher's Financial Mythbusters

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When I talk about 'investment risk', what comes to mind? For most people, it's volatility. Many investors act as though 'risk' and 'volatility' are interchangeable. And they often are! Volatility is a key risk that, most of the time and over shorter periods, investors feel most keenly.

It can be heart-stopping to watch your shares lose up to 20 per cent in a correction, let alone 30 or 40 per cent or more in a bear market. But, ultimately, equity investors put up with volatility because, long term, they should get rewarded for that volatility.

However, volatility isn't the only risk investors face. For example, people often believe bonds are safer. But no bond is risk-free. Bonds face 'default risk' - the risk that the issuer delays payments or goes bust. Default risk in US Treasuries is low, so professionals often refer to it as the 'risk-free' rate.

INTEREST RATE RISK

But that's not exactly right. Why? There's also 'interest rate risk' - the risk that interest rates, moving in either direction, impact your return. In falling interest rate environments, investors may find it difficult to roll over funds from maturing bonds into something with a similar yield.

That's one half of interest rate risk. As I write, interest rates across the board are almost as low as they've been for the adult life of most readers. The chart below shows yields on 10-year Treasuries since 1980 - rates have fallen with volatility nearly the entire time to generational lows.

historic-ten-year-treasury-yields

Still, at some point interest rates will rise again, which can erode the value of bonds you hold now. You may decide to hold your bonds to maturity. Fine, but 10 years is a long time, and 30 years is much longer!

And if you must sell, even a small interest rate move can seriously impact your return. A 1 per cent upward rate move gives you an implied -5.5 per cent annual return on your 10-year Treasury; a 2 per cent move an implied -12.9 per cent return on the 10-year, or -29.6 per cent on the 30-year.

There's inflation risk, political risk, exchange rate risk, liquidity risk. Volatility is decidedly not the only risk investors face.

The way people think about food and investing often parallels. In food, they want multiple things at the same time. They don't just want nutrition; they want food to look and taste good. But what they want from food can shift, fast.

And what they feel as risk is what they want at a point in time that they think (or fear) they're not getting. They don't think about the things they are getting.

For example: maybe they're forced to eat cereal at night, as there's nothing else in the house. They don't like the fact that they're eating something in the wrong order, and they feel foolish for it. Those are two risks. They don't think about the need that's being fulfilled, i.e. basic sustenance.

How does that relate to investing? As with dining, what people feel as risk is often that which they aren't getting at a point in time, regardless of whether their other objectives are met. You might hear investors say: 'I don't want any downside volatility!' They're feeling volatility and want protection from it.

OPPORTUNITY COST

Then, if stocks go on a long, sustained tear, they might feel they're missing out. That is felt as another kind of risk, 'opportunity cost' - the risk of taking or failing to take actions now that results in lower returns than you would have gotten otherwise. And it can be a killer.

For example, you may have a longer investing time horizon, but be mostly concerned about shorter-term volatility. You may then choose too large an allocation of fixed income.

Over your longer time horizon, because you don't have enough exposure to equities, you likely get lower returns and increase the likelihood you miss your long-term objectives - maybe by a wide margin.

What makes opportunity cost such a killer is the fact that its effect may not be obvious for some time. 20 years from now, if you look back and discover that you really needed to annualise 9 or 10 per cent on average but your lower short-term volatility portfolio yielded much less, that's a massive error that may be beyond help.

To reduce the odds you run out of money too soon, you may have to cut your spending. And that can be hard to do, particularly if you're already retired or nearing retirement.

Yet most investors don't think much about opportunity cost. It tends to pop up after a bull market has been running for a while, and coincides with extreme optimism or even euphoria, when they are keen to chase the next big thing. But typically, they default to focusing most on volatility and less (or not at all) on opportunity cost.

Which is perverse! Yet most people will agree that investors tend to be bullish when they should be bearish and the reverse.

So if stocks rise in around 73 per cent of all calendar years, people are going to be naturally bearish more often than not - and they're going to downplay opportunity cost as a risk.

Don't do it. Volatility is a key risk, but not the only one. For many investors with long time horizons, not accepting enough volatility - opportunity risk - can be more devastating long term.

Ken Fisher is founder and chairman of Fisher Investments.


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