Risk and Volatility

A reader writes in, asking:

“What do you think about using Vanguard’s REIT ETF rather than CDs or a savings account as a way to save up money for a down payment on my first home? My line of thinking is that a REIT fund would likely outperform such low-risk investments, and if the fund has a loss, it might not even be a problem because it’s likely that real estate prices will be falling as well.”

There’s certainly a degree of common sense appeal to such a strategy.

• Like any stock fund, it’s true that a REIT fund will earn higher returns than CDs or savings accounts over most periods.
• And it’s true that a REIT index fund or ETF would usually be more closely correlated to home prices than other stock investments would.

But it’s still a risky way to save because you can’t count on a high correlation between the price of the home you want to purchase and the performance of a REIT index fund or ETF.

Commercial Real Estate vs. Residential Real Estate

Most REIT index funds have the majority of their assets invested in commercial REITs rather than residential REITs. (See, for example, the holdings of Vanguard’s REIT index fund.) As a result, there’s a real possibility that home prices could be rising (making your desired home purchase more expensive) at the same time that the price of your REIT fund is falling due to a poorly-performing commercial real estate market.

Real Estate is Local

It’s also important to remember that home prices don’t move in lock-step across the country. Home prices could be falling overall, while home prices in your area are holding steady or even climbing. If your REIT fund’s price falls along with most home prices, saving for a home in your area will be a challenge in such a scenario.

To pick two examples off the top of my head: Asheville, North Carolina and Hot Springs, Arkansas — two places we had considered moving to last year — both saw home prices increase through 2007 and 2008. Trying to save for a down payment in one of those cities would have been rather difficult if you were using an investment that, like Vangaurd’s REIT index fund, lost almost half of its value (47%) over those two years.

It’s Not Crazy. But It’s Not Safe Either.

Using a REIT fund to save for a home down payment probably would make more sense than using something like a total stock market index fund, because the REIT fund probably would have higher correlation to home prices in your area. But again, that correlation isn’t going to be very reliable.

And a REIT fund will likely earn you greater returns than a savings account would. But when I say “likely” here, all I mean is “greater than 50% probability.” It’s not at all something you can count on. And it makes the worst-case scenario significantly worse (home prices increasing while the value of your savings is decreasing — something that can’t happen with a savings account).

In short, unless you’re very flexible with regard to when you purchase the home (such that you wouldn’t mind waiting several years for your REIT fund to bounce back after a decline), I’d suggest sticking with the normal advice: Use something safe for short-term savings.

January 4, 2012 1 comment

Karl writes in to ask,

“The old ‘age in bonds’ rule would have me put approximately one fourth of my portfolio in bonds. But I’m reluctant to put anything in bonds because I’m afraid that bonds (Treasuries especially) are in a bubble much like tech stocks in the late 90s. Assuming the bubble pops and interest rates come back up to more normal levels, bond prices will fall, right?”

It’s true, of course, that interest rates are very low right now. And it’s true that when rates come back up, bond prices will fall.

But Stocks Are Still Riskier

If risk of loss is what you’re concerned about — and saying you’re afraid of a bubble suggests that’s the case — then moving more money into stocks doesn’t make one bit of sense. Even with interest rates at historical lows, stocks are still riskier and more likely to have a large drop in price at any given time.

For example, from its peak in 2007 to its trough in 2009, Vanguard Total Stock Market Index Fund fell approximately 50%. For Vanguard’s Total Bond Market Fund (with an average duration of 5.1 years) to fall by that much, market interest rates would have to increase by almost 10%. In other words, interest rates would not just have to come back up to normal levels, they’d have to go shooting far beyond that.

And if you decided to stick with a short-term bond fund, the risk of significant loss due to a rise in interest rates would be even smaller.

Asset Allocation Based on Risk Tolerance

If the idea of incurring a significant loss in your portfolio really scares you, you need to be thinking about limiting your stock allocation.

My own personal favorite rule of thumb for asset allocation is to spend some time thinking about your maximum tolerable loss, then limit your stock allocation to twice that amount — with the line of thinking being that stocks can (and sometimes do) lose roughly half their value over a relatively short period. For example, if the idea of a 30% decline really scares you, I wouldn’t go higher than 60% stocks.

As far as your bond allocation, if you really are convinced that rates will be increasing soon, using a relatively short-term bond fund will minimize your exposure to interest rate risk.

I’d add the caution, however, that just because rates are low right now doesn’t necessarily mean they’re likely to be increasing any time soon. And by sticking with shorter-term bonds, you’ll be earning a lower rate of interest while you wait for rates to come back up.

November 14, 2011 9 comments

Credit where credit is due: The inspiration for this article comes from a recent post on the Bogleheads forum: “A Time to Evaluate Your Jitters.” I strongly encourage you to read the post, as the author made his points more eloquently than I’ll be able to.

In the last week we’ve mentioned two productive things to do during a market downturn:

1. Rebalance your portfolio, and
2. Check for tax-loss harvesting opportunities.

Today let’s add a third: Get a first-hand evaluation of your risk tolerance.

Is Investing Supposed to Be This Difficult?

If my email inbox is any indication, many investors have found it difficult to stick to their investment plans this week. Their plans call for rebalancing (which in this case means selling bonds and buying more stocks), but they’re nervous about doing so.

Rebalancing isn’t supposed to be easy. Selling your better-performing assets to buy more of your worse-performing ones is difficult for most investors.

But it’s not supposed to give you an ulcer or heart attack either. If you’re experiencing that degree of hesitance to stick to your original plan, what you’re getting here is first-hand, concrete evidence that your risk tolerance is not as high as you thought it was.

If the only way you’re going to be able to sleep at night is to use a lower stock allocation than your original plan called for, then so be it. It’s a costly lesson, but it’s a valuable one too.

So don’t waste it.

Whatever stock/bond allocation you end up settling on, do not move to a more aggressive allocation in the future. Otherwise you’re likely to repeat the same mistake when the market takes its next downturn.

A lower-risk, lower-expected return allocation that you can stick with is much better than a higher-risk, higher-expected return allocation that has you panic-selling in every bear market.

But This is Unprecedented!

Several readers have told me that this week has been an exception. They’re normally risk-tolerant, but this decline has been particularly difficult to deal with because the events causing it are so unprecedented.

But that’s the point. It’s always unprecedented.

Think back to the end of 2008. The housing market was crashing. The biggest, most famous financial institutions were failing one by one, and experts were predicting that our entire financial system would literally collapse if the Federal government didn’t step in to hold the pieces together. It was unprecedented.

Or think back to 2001. The technology sector upon which we’d pinned our hopes of wealth and prosperity had started to come to pieces. Then, after about a year of the market declining, terrorists attacked us on our own soil, killing thousands of people. To say that that was unprecedented is an understatement.

Risk tolerance isn’t just about your ability to deal with abstract market declines. It’s about your ability to stay calm while your portfolio is tanking and you’re being inundated with news of frightening, sometimes genuinely catastrophic, I-never-thought-this-could-happen type events.

August 10, 2011 5 comments

In a recent guest post, the author (Neal) argued that an investment in real estate becomes less risky the longer it’s held. In the comments, two readers (Dylan and The Finance Buff) disagreed. One even argued that such an investment becomes more risky the longer it’s held.

So who was right?

As far as I can tell, they all were. They were just using different definitions of risk.

Traditional Risk Measurement

In traditional finance literature, variability (specifically, standard deviation) of annualized returns has often been used as a measurement of risk.

Perhaps the most famous example of someone using this definition is Jeremy Siegel in his mega-selling Stocks for the Long Run in which he argued that stocks become less risky the longer you hold them because (historically in the U.S.), the standard deviation of inflation-adjusted annualized stock returns has been smaller over longer periods than over shorter periods.

Variation in Total Ending Value

Others argue that risk is better measured as variability of total ending values. This definition turns the “stocks become less risky with time” idea on its head. When measured in terms of ending value, stocks (and other investments with highly variable returns) become more risky the longer you hold them because, when compounded over a few decades, even a slight difference in annual returns leads to a dramatic difference in total ending value.

Probability & Magnitude of Shortfall

Still others argue that the best definition of risk involves probability and magnitude of a shortfall–that is, the risk of not having the amount of money you need when you need it.

Using this definition, the riskiness of an investment depends on your expectations for it and on how you plan to use it. For example, even if an investment steadily delivers 4% inflation-adjusted returns every single year, it’s going to be a problem if your financial plan was relying on 7% returns.

Probability & Magnitude of Loss

Finally, it can be helpful to consider risk as probability and magnitude of loss. But, as with the previous definition, this one varies from person to person. For example:

• Are you going to experience significant stress any time you sign into your brokerage account and see that the portfolio value is lower than last time you checked?
• Or, for instance, would you be OK as long as the value is higher than it was, say, three years ago?
• Or would you be OK as long as the decline is smaller than a given percentage?
• Or would you be OK as long as the decline is smaller than a given dollar value?

Why Is This Important?

I think there are two useful takeaways here.

First, when you hear writers, financial advisors, or anyone else use the term “risk,” be aware that they could mean any of several different things. If the meaning isn’t clear, ask.

And more importantly: When assessing your risk tolerance, put some thought into what type(s) of risk you care most about. This information will play an important role in selecting an appropriate asset allocation.

July 20, 2011 3 comments

The risk/reward relationship is likely the most fundamental concept of finance. But “risk” is such a vague term that I think it can be helpful to break it down into more tangible components.

Time as a Component of Risk

When it comes to money, time is a key ingredient. It can take an otherwise very risky investment and make it significantly less risky–possibly even conservative.

For example, a friend of mine is buying a condo in Manhattan. While prices have come down recently, they are still astronomically high. My buddy is worried about buying this condo because he fears that prices might drop. If he does buy the condo, the reward is pride of ownership and (possibly) a good long-term investment. But the risk that he’s thinking about is the risk of overpaying for his pad.

Why is he thinking about that?

He’s completely forgotten about the element of time. He’s not going to sell his condo this year or next. He’s not going to fund his down payment by going into credit card debt. He’s got the cash just sitting there. And the odds are, he’ll hold on to that place for the next 20 years. It doesn’t matter what the price of the condo does over the next few years because that will have no impact on him.

When you think about risk and reward, don’t forget about time. Consider your risk over your intended or likely time frame.

Probability of Loss

The next component of risk is probability. Yes, it’s important to understand what a bad outcome might look like, but in order to make a good decision, we have to be mindful of the chances of something catastrophic happening.

Think about driving your car. There is always the possibility of getting into a terrible accident when you get into an automobile. But the odds of a catastrophic accident are so remote that most people don’t have a problem getting into a car and driving downtown.

Investments are no different. When you make an investment, there are always risks. You can take steps to reduce those risks, but you can never eliminate them. Because risk exists, does that mean you shouldn’t take action? It may…if the probability of that bad outcome is significant. But if the probability is very low, you (usually) shouldn’t let it stop you.

Magnitude of Loss

The final component of risk is magnitude. The odds of something happening might be very low, but the magnitude of the consequence might be so great that you still can’t take the chance.

Consider robbing a bank: Even if you have what appears to be the perfect plan, it’s a bad move. The idea of going to jail is so repulsive that it makes the proposition a non-starter. In this case, the magnitude of the consequence is so high that it almost doesn’t matter that the odds of experiencing that negative outcome are low.

Similarly, even if you have a “sure thing” investment, it’s still important to diversify. If you put everything into one ostensibly low-risk investment and that one-in-a-million bad outcome occurs, your life savings will be history, and you won’t have enough money to retire.

When considering magnitude of risk, rather than thinking in terms of dollars, it can be helpful to think in terms of impact. For example, Bill Gates can lose $10,000, and it won’t impact him at all. He can still live on any island he likes. You might also be able to lose $10,000 without it having a huge impact on your life. But somebody struggling with debt can’t afford that risk. Such a loss would be a game-changer and, therefore, not an acceptable proposition.

In summary, when investing, you need to understand what you are risking, how likely that risk is to appear, and how the magnitude and probability of that risk change over time.

About the author: Neal Frankle is a Certified Financial Planner in Los Angeles and runs Wealth Pilgrim.com–a personal finance blog for people interested in making smart decisions about their money.

July 4, 2011 2 comments