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Risk can be a quotient topic. equations can change when divisible by time but they can also change with knowledge. Some of the long-held, common sense regarding risk might actually be more fallacy than fact. When considering your investment time horizon, Famed Boston University professor Zvi Bodie and financial planner Paula Hogan recommend that investors focus on how much they are willing to lose first, not how much they are willing to gain.
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Does risk really decrease over your investment time horizon?
There is a common investing axiom that investing risk diminishes with time. Bodie and Hogan, in a piece titled 'For Long-Term Investors, the Focus Should Be on Risk,' think this concept should be questioned.
Typically, data dating back to 1926 shows that over such a long time horizon,. 'But this does not tell the whole story,' they write. 'Stocks can be risky, even in the long run.'
If risk declines with time, why does , as evidenced through the CBOE VIX index, increase with time?
'The big fallacy abroad in the land at the moment is that time horizon is a reliable and sole proxy for risk,' Bodie and Hogan reason, pointing to a paradigm that says the longer the investment time horizon the more exposure to the stock market is warranted.
'What the current is the fact that as the investor's time horizon lengthens, the range of possible ending values for the portfolio also increases, and that these widening ranges include the low, but still positive possibility of a whoppingly low actual versus expected portfolio ending value,' the pair write.
Lower expected returns can occur and last for years, they note. Plus, if an investor were to enter the market at the wrong time – such as high valuations that ultimately would fall – the impact on a portfolio can be 'devastating' even .
Even FINRA, which regulates investment advisors, notes that time can be both a friend and foe to investors. "If you had planned to retire in the 2008 to 2009 timeframe—when stock prices dropped by 57 percent—and had the bulk of your retirement savings in stocks or stock mutual funds, you might have had to reconsider your retirement plan," FINRA investors while noting that over multiple decades investing returns have generally been positive.
Averaging into the stock market each month for numerous years consistently through bull and bear markets has generated more consistent results. This allows investors who might have invested near all-time highs just before a market sell-off to rebound afterward.
The real challenge for investors, however, might be found in .
Investors shouldn't consider gain first, but rather how much loss they can tolerate on their investment time horizon
Bodie and Hogan note the paradox of how investors interpret risk. Those who are risk-averse generally open up to the concept of accepting more risk once they understand investing. Likewise, those who are willing to accept high degrees of risk are more pragmatic once they understand investing. Personal background also comes into play as does a psychological profile.
The willingness to accept risk is not always based on, but an underlying understanding of the investment process and individual investors point in life.
For smaller investors, a $100 monthly contribution to a 401K plan can be meaningful, other times it might not matter. That concept remains the same at different financial stages.
'The first $1 million changes your life,' as does the second million. 'But at some point even an extra $1 million doesn't change the way you think and feel about your financial goals.'
Risk is not the place to end a conversation about investing; rather, it is the place to start.
'As you continue to be with information about how much you can earn in the investment markets,' Bodie and Hogan advise investors, 'remember that when determining the optimal allocation for your portfolio, it's best to focus first on how much you are able and willing to lose.'
H/t AAII Journal. Read the full article .
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