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Weighing Risk

Jonathan Clements  |  February 11, 2016

WITH STOCKS in turmoil, investors are once again fretting over risk. But what aspect of risk should we worry about? Whenever the notion arises, it’s worth contemplating three questions.

What are the odds of success or failure? Over the past 50 years, the S&P 500 (with dividends reinvested) has lost money in 11 calendar years, equal to once every four or five years. With odds like that, an occasional losing year should be no great surprise. The implication: Stocks may be a fine long-run investment, but they’re a risky venture for anyone who has a short investment time horizon—or a short emotional time horizon.

Keep in mind that, during this 50-year stretch, we had one three-year losing streak (2000-02), as well as a two-year drubbing (1973-74). Thus, it might be more accurate to say that, over the past 50 years, we’ve had eight periods of market unpleasantness—a few of them extremely unpleasant. This count excludes 1987, when the S&P 500 managed to lose more than 20% in a single day, and yet still posted a gain for the year.

What are the consequences? This is the most important of the three questions. If you don’t need to sell stocks any time soon and you aren’t given to panic, the consequences of a market decline are hardly worth contemplating. In fact, it could prove to be a bonanza if you take the opportunity to buy more. On the other hand, if you do need to sell stocks in the near future or you are given to panic, the consequences of a market decline could be severe and it might make sense to dial back your portfolio’s risk level, even though the S&P 500 is already down 14%.

What’s uncertain? While risk can be measured, uncertainty can’t be. For instance, I don’t know how you would calculate the odds that the U.S. tax code will be rewritten so that stocks become more or less attractive. Could corporate tax rates be cut? Could capital-gains taxes rise? Both are clearly possibilities, though it’s hard to say how significant those possibilities are.

Indeed, I’m not sure how useful it is to contemplate uncertainty, except to acknowledge that bad stuff could happen—including bad stuff that isn’t even on our radar screen. That should make us a tad more humble in our investment choices, so we think long and hard before straying too far from a globally diversified portfolio of stocks and bonds.

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