Most investors are familiar with risk questionnaires. These are typically provided by 401(k) plans, mutual fund companies and financial planners developing "customized" investment portfolios.
But what these questionnaires typically measure may have little connection to investors' actual goals. Their focus on short-term risk and return can steer respondents toward moderate portfolio allocations and away from more aggressive and better-performing, long-term allocations.
According to the Investment Company Institute, roughly half of all individually directed stock investments are in long-term IRA and 401(k) accounts. Many accounts held outside of qualified accounts are also for longer-term goals, such as a child's college savings account, are as a supplemental retirement accounts.
And yet typical questions will revolve around participants' reactions to short-term investment risk.
Vanguard Group's online questionnaire poses this statement: " Generally, I prefer investments with little or no fluctuation in value, and I'm willing to accept the lower return associated with these investments."
Respondents are given five possible responses, from "strongly agree" to "strongly disagree." But the question itself is flawed because there is no time frame given for fluctuation, nor is there any way to quantify the cost of lower return.
Psychologists say that most individuals are risk-averse, meaning that answers would tend to skew toward accepting a lower return for less risk. Choosing the "strongly agree" option would skew a portfolio towards investments in short-term government bonds; picking "strongly disagree" would steer an investor more toward an allocation in equities.
But how would answers change if we rephrased the question?
"Based on the past 20 years of returns, would you prefer an investment that had very little annual fluctuation and would grow to $30,304 in 20 years and $52,753 over 30 years, or would you accept annual losses as high as 40 percent to have $44,747 in 20 years or $94,655 in 30 years?*
Or more succinctly, "Would you be willing to accept extensive short-term volatility in return for potentially having twice as much money when you retire?"
Of course, history is no guarantee of future results. But consider the perspective of the last 20 years -- there have been two major bear markets that brought the stock averages down nearly 50 percent in both instances. The same economic backdrop that has hampered the stock market has bolstered short-term bond investment returns with falling interest rates.
[See: The 9 Best Investors of All Time.]
With the yield on the five-year treasury now yielding just 1.17 percent, it is mathematically impossible to duplicate the 5.7 percent average annual return from the past 20 years.
In another sample question -- this one from Rutgers University -- investors are asked to choose which investing outcome is the most preferable.
-- A return ranging from zero to $200.
-- A return ranging from a $200 loss to an $800 gain.
-- A return ranging from an $800 loss to a $2,600 gain.
-- A return ranging from a $2,400 loss to a $4,800 gain.
The question presumably refers to a short-term horizon -- picking the first choice leads to a lower risk score than picking the last choice. If the question referred to long-term preferences, the results would be the opposite.
In his book "Stocks for the Long Run," Jeremy J. Siegel, a professor of finance at the Wharton School of the University of Pennsylvania, argues that despite the annual volatility of stocks, over the long run they produce superior returns to more conservative asset classes, such as treasury bills or bonds.
Specifically he states, "No other asset class -- bonds, commodities, or the dollar -- displays the stability of long-term returns as do stocks. In the short run, however, stock returns are very volatile. ... Yet these short-term swings in the market, which so preoccupy investors and the financial press, are insignificant compared with the broad upward movement in stock returns."
Specifically back to the risk question above, using 20-year rolling periods from 1802-2012, the best and worst return for a single 20-year period was 8.3 percent and -3 percent for Treasury bills. Not bad. But stock returns ranged from a high of 12.6 percent to, at their worst, a gain of 1 percent. So as Seigel points out, stocks demonstrate less risk and more return over longer (20-year) periods.
The only real question every investor needs to ask themselves is, "What is my goal?" and then build a portfolio to meet that goal and not be sidetracked by other valid, but not relevant considerations.
William DeShurko started in the financial services industry in 1987 and formed his own practice in 1994. He is a portfolio manager for Covestor, the online investing marketplace, and owner of 401 Advisor, LLC a registered investment advisor in Centerville, Ohio. After following fads, phases, and products of the day for nearly 30 years, he hopes that his insights and experience can help today's investors navigate the financial markets. You can read more of his insights at www.deshurkoblog.com or contact him directly at firstname.lastname@example.org.
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