The relative rewards of risk

When people decide to invest in the stock market, there’s almost always an aversion to losing money. There’s a risk that investors will receive less in the future than what they contribute in the present, and that’s often enough to scare people away indefinitely. When others invest, they conceptualize risk as an opportunity cost of missing out on the next big IPO or private equity success story. To them, the risk of bad timing and missing large returns on their capital drives their investing behavior. And this “opportunity cost” risk must be mitigated for these high-return-seeking investors when allocating money in search of returns above and beyond what an index fund can deliver. After all, there has not been a single billionaire who made it big off matching the market with an index fund. Not one.

Great investors have taken chances to invest in businesses that have benefited millions of people, and they’ve been rewarded handsomely for those efforts. This includes entrepreneurs who have invested their time, money, and effort to create value for others. Instead of allocating their money in the stock market, they chose to take a risk and invest in their idea in hopes of earning a higher return than what the market was offering at that particular point in time.

Contrary to this relative aggressive style of investing, is a passive strategy of buying and holding index funds for the long term. And with time on your side, you’re almost guaranteed to earn an average return of 5-7% over several decades, just by buying and holding a basic S&P 500 fund; by no means a bad way to go when considering the compounding effects of those returns over longer periods of time. To highlight the concept of compound investment returns, if you earned a return of 6% per year, on average, you would double your investment every 12 years. For example, if you invest $50,000 and earn 6% in the first year, you’ll earn $3,000 after year one. Starting year two with $53,000 and earning another 6% will net you $3,180 instead of the initial $3,000. In the 20th year, your balance in this hypothetical example will have increased more than 200%.2 Staying the course and investing for the long term can be a lucrative endeavor.

Time is on your side

Based on historical statistics, the chances of losing money in the stock market after one year are greater than 25%. But, if you invest for 10 years–based on what has happened in past years–that number would drop to about a 4% chance of loss. After 20 years, historically, that number goes to zero.1 Zero chance of losing in the stock market after 20 years can be a selling point for investors, or it can be a great deterrent for those who want their money to work for them in a much more impactful way. Some would no doubt say that breaking even after 20 years in the stock market is an awful way to invest; and they wouldn’t be wrong. Skeptics would also point out that past statistics are by no means guaranteed to repeat, and they wouldn’t be wrong either.

There are many more ways to invest than by simply buying stocks and bonds, and although many of these investments might carry higher risks, the rewards could potentially outweigh any realized losses. And this is where diversifying over several asset classes with the intention of seeking negative correlation with the stock market can truly pay off over various time periods.

Think differently

In order to properly diversify, one has to minimize the risks associated with the overall stock market. In other words, if the entire stock market is in free fall like it was in October of 1987, the chances of investors somehow avoiding massive losses are very improbable. But, if an investor decides to allocate financial resources to create a business that is in high demand over that very same time period, chances are it is less likely that the losses will be exactly correlated with that of a loss in the stock market. Of course, those losses could be more severe, but they could also yield positive returns precisely as everyone else is losing their shirts.

Burton Malkiel, author of the perennial best-selling book A Random Walk Down Wall Street was correct when he wrote: “risk, and risk alone, determines the degree to which returns will be above or below average.” Investing in your own business, or allocating capital with someone running a promising startup are ways in which investors can attempt to mitigate the systemic risks associated with investing in the stock market. Real estate investments, limited partnership interests, and even certain alternative investments like hedge funds may provide much needed diversification when markets head south. It must be noted, however, that these asset classes are not always negatively correlated with the stock market and often carry more risk and higher costs. Nonetheless, prudent investors consider these asset classes in conjunction with a portfolio consisting of equities and bonds to optimize risk-adjusted returns.

Risk and return are inseparable. You cannot earn large returns without taking on large risks. But the greatest risk of all comes from overconfidence in one’s ability to outsmart everyone else they’re trading with, since there must be a buyer and a seller on each side of a trade. Warren Buffett said it best when he said “we don’t have to be smarter than the rest. We have to be more disciplined that the rest.”

Disciplined investors remain diversified in both bull and bear markets, maximize risk-adjusted returns, and recognize their limitations when it comes to earning a return on their hard-earned capital.

1. Based on calendar-year returns of the specified indexes, stocks have had a negative 1-year return 28% of the time, a negative 10-year return 4% of the time, and a negative 20-year return 0% of the time. Data covers the period 1926–2014 and uses the Standard & Poor's 90 from 1926 to March 3, 1957; the S&P 500 Index from March 4, 1957, to 1974; the Wilshire 5000 Index from 1975 to April 22, 2005; the MSCI US Broad Market Index from April 23, 2005, to June 2, 2013; and the CRSP US Total Market Index thereafter.

2. Vanguard Research, How Risk, Reward, and Time are Related.