Buffett has famously said, “risk is not volatility.” This article isn’t about that. This article is about what keeps me, as an investment manager for retirees and soon-to-be-retirees, up at night.
“Risk” in the context not only of investing, but of your life, boils down to two basic problems of investing in stocks. First, the longer your holding period, the more concentrated your portfolio becomes. Most stocks trading in the market today will have a return of 0% or less than 0% going forward. This is based on the observation that this has happened from virtually every point in time we have data for. Pick a date, look at the stocks trading on that date…more than half of them won’t produce positive returns going forward. In the short run, maybe half of them do well, but in the very long run, almost all of the returns of the US stock market averages, come from a very small number of very successful companies. The rest fail to deliver. What should be concerning about this is the possibility that a stock that grows to represent a huge part of your portfolio subsequently becomes one of those stocks that delivers a 0% or negative return. Oh, and more than a few of these stocks go to zero. So your $1,000,000 investment, which has done so well up until now, could go to $0 over the next 10 years. Which is the same as never having had that $1,000,000. Only worse.
The other problem with investing in the stock market, is that the market averages routinely have periods of 5-10 years where your returns are flat, or negative. That’s not such a big deal if you’re 20, 30, or even 40 years old with 10-30 years left to until retirement. “Let’s buy more stocks while they’re on sale,” you should be saying. But when you’re getting really sick tired of working (or are unable to work), and you’re looking to retire in the next 10 years, that lost decade becomes a serious risk. Best case, you defer your retirement for that decade. Worst case, you retire right at the start of it, and see a radical shrinkage in your net worth that your retirement income never recovers from. This is called “sequence of returns risk.” Which is a fancy way of saying that your portfolio gets effed worse when you have 10 years of shitty returns at the beginning of your retirement than at the end.
The final risk that keeps me up at night is one you’re probably familiar with. Inflation. Specifically, surprise inflation, which is the type that jeopardizes the underlying value of your investments while simultaneously jacking up your cost of living. The “you-better-invest-your money-because-losing-2-to-3%-a-year-over-a-35 year-retirement-really-adds-up” variety of inflation that your 49-year-old Edward Jones advisor talks about, ain’t shit. I know what to do to deal with that type of inflation. Everybody does. Surprise inflation, however, is where the ulcers come from because no one knows what to do about it, how bad it will get, or when it will end. Surprise! Worse, very few assets do well in an environment with surprise inflation. At an operational level, surprise inflation makes everything in a business harder by playing havoc on your margins and cash flow. You’ve probably seen something similar in your personal life. Consider what it would have taken to get a home renovation project done in 2019. From beginning to end the thing may have taken 3 months. In 2022, you’re probably hearing that it will take a few weeks just to get an estimate, and that the start date for actually doing the project is pushed back until next spring. Oh, and you’re still paying top dollar because these bids are done based on what the contractors think materials and supplies might cost next spring, which is also anyone’s guess and they’re not showing up to work every day so that they can lose money. Too, part of the reason they’re booked out so far is because they just can’t get the supplies and labor today anyway, regardless of what they pay. That’s a tough environment to run a business in.
On top of operational risk in a surprise inflation scenario, you have the problem of rising interest rates, which massively suppress the justifiable valuation for these now embattled businesses. Whereas a high-growth tech company might have been worth $100 billion a year ago, the justifiable price today might be closer to $25 billion. Which is a 75% loss. Which requires a 300% return to get back to where you were. Meanwhile, you were trying to achieve FIRE (financial independence retire early) by 40, and good luck with that now. Hopefully you like your job.
So yeah, volatility isn’t the same as risk. And Buffett’s right in one very important sense: risk is usually present long before it reveals itself as volatility. But sometimes volatility (just by itself) means not being able to meet your financial goals, and losing years of your life you thought you had saved up enough for. And that’s the real risk.