Are Stocks Worth the Risk?

There is no doubt that the market’s -38.1% return of 2008 was painful.[i]   To add insult to injury, it seemed investors were on a never-ending roller coaster ride.  Is investing in equities worth the risk?  Many investors are considering forgoing the risk of stocks (volatility or investment risk) and putting their money in “safer” investments such as T-Bills.

 

Market Returns

The market return of 2008 was unusual – but not unprecedented.  Over the period of 1927-2008, the market produced negative annual returns close to or below 30% for 5 individual calendar years.

 

2008    -38.10%

1974    -27.95%

1937    -34.61%

1931    -44.36%

1930    -28.83%

On the positive side, the annual market return was greater than 30% for 15 individual calendar years of 1927-2008.  Fortunately, extreme positives have outweighed extreme negatives.

 

Why Take Risk?

   

The simple answer: inflation.  Most discussions of investment performance focus on nominal returns.  If you are a long-term investor, then performance should be measured in terms of real return.  Think of real return as your personal bottom line; how your investments perform after inflation is backed out.

 

·        A dollar invested in Treasury bills between 1927 and 2008 earned a 3.7% total return. Yet, according to the U.S. Consumer Price Index, inflation during that same period averaged 3.1%. The T-bills' real return? Only 0.6%.

 

·        A dollar invested in U.S. Total Stock Market[i] over this period generated a 9.5% total return. The real return: 6.4%.  That's head and shoulders above T-bills.

 

How does real return affect your personal bottom line? 

 

The average cost of milk in 1998 was $3.16 per gallon.  In 2008, the price rose to $4.28.  That is an annual increase of 3.08%.  In this example, your personal savings would need to earn 3.08% a year.  If not, your savings would not have kept up with inflation.  By investing in “safe” investments you can avoid investment risk, but have introduced a different type of risk – purchasing power risk.

 

How Much Risk?

 

Determining how much risk you are willing to bear is a subjective endeavor.  There are many factors to consider:

 

How many years until you plan to retire?

How much are you able to save each year?

Will your savings be your only source of income after you stop working?

For an informative discussion on how investors can manage both investment risk and purchasing power risk, view the following video presented by David Booth, CEO of Dimensional Fund Advisors.

http://www.dfaus.com/library/videos/retireme/



[i] Fama/French Total US Market Index provided by Fama/French from CRSP securities data.

 


 

[i] Fama/French Total US Market Index provided by Fama/French from CRSP securities data.

[i] The market returns were calculated using the cap-weighted market portfolio of the NYSE-Amex-Nasdaq stocks.