You often hear stocks described as a risky asset class. What people are getting at when they say that is that stock prices at some times go dramatically up and at other times go dramatically down. Most observations that stocks are risky are more properly viewed as observations that stock prices are volatile.
It’s not the same thing.
The risk that you are worried about as a middle-class investor seeking financial freedom early in life is that investing in stocks will cause you to lose money and thereby not make the progress on attaining your financial freedom goals that you were hoping to make. If you can invest in stocks in a way that provides a good deal of protection against the possibility that you will lose money, you have transformed the stock investment class from a risky one to a non-risky one.
You can do this.
Please take a quick look at The Return Predictor (click the button with that title on the left side of this page). The Predictor tells us that the most likely 10-year annualized real return for a stock purchase made today is 1.3 percent. That number suggests that there is a good deal of risk attached to buying stocks at today’s prices.
Stocks are not going to provide an even 1.3 percent return for 10 years in a row. There will be some years in which the return will be a good deal better than that. That obviously means that there will also be years in which the return will be a good deal worse than that. There could be some awful years in a 10-year patch of returns generating an overall return of only 1.3 percent (and it is possible that the 10-year return could drop as low as a negative 4.7 percent).
So stocks today are risky, no?
Look at the Predictor’s number for the most likely 30-year return — 5.4 percent. That’s not bad at all. That’s more than double what you can get today from Treasury Inflation-Protected Securities (TIPS).
So stocks are not risky today then, right?
Stocks are both risky and non-risky today. The level of risk depends on the mix of purposes to which you will be putting the money you are investing in stocks.
If the only possible purpose to which you will put the money is to finance your old-age retirement, and you are today decades away from retirement, it’s the 30-year number that matters. For you, stocks are not too risky today, despite their high valuations.
The flaw in most of the conventional investing advice is the assumption that most middle-class workers invest only to finance their old-age retirements. We all do indeed invest for that purpose. For most of us, though, the money in our portfolios serves multiple purposes. Perhaps we want to have money available to help our daughter get through college. Perhaps we want to have money available to start a business if our job turns sour. Perhaps we like the idea of having a healthy amount of savings because of the feeling of financial security it provides.
If those sorts of purposes apply for you, then looking just at the 30-year return number does not do the job for you. You should look at the 30-year number because you are investing partly to finance your retirement and the 30-year number tells you something important about how stocks can help you to attain your retirement financing goals. But you need to look at the 10-year number and the 20-year number too, if you are investing partly to advance non-retirement purposes.
For most of us, it is not too risky to direct a small percentage of our portfolio to stocks today because it would not cause us panic to see a large percentage loss in an investment class that comprises only a small percentage of our portfolio. For most of us, it is too risky to direct a large percentage of our portfolio to stocks today because it would cause us panic to see a large percentage loss in an investment class that comprises a large percentage of our portfolio.
Stocks are risky and non-risky at the same time. They are non-risky when held in small amounts, and the risk grows as you allocate more of your portfolio to stocks. It is your personal financial circumstances and life goals that determine how much of your portfolio you can direct to stocks before they become too risky.
You are in control. That’s why I say that stocks are less risky than you think. It’s not really a risk if you control it. Just lower your stock allocation to the point at which stocks are no longer risky for you and the risk attached to stock ownership for you has gone “poof!”
Stocks are a high-risk investment class for others. Stocks do not need to be a high-risk investment class for you. You are in control. Say “no” to high-risk stocks. Don’t buy stocks to the point at which you transform what should be a low-risk or moderate-risk asset class into a high-risk one.