Redefining risk

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Don Lawson
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Redefining risk

Post by Don Lawson »

Most long-term investors have an incorrect view of risk. They define risk as a loss of principal when the real risk to a long-term investor is the loss of purchasing power over time.

With this in mind, all asset classes BUT equities are extremely risky. Equities are the only asset class with a lengthy track record of overcoming this risk. When long-term investors add cash, gold, and even bonds to their portfolio they are hurting their chances of overcoming this risk. And frankly, I'm surprised how easily people lose sight of this.
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Random Musings
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Post by Random Musings »

IMHO, there are two major questions - how do we define "long-term" and will history repeat itself during the defined "long-term" period.

RM
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Don Lawson
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Post by Don Lawson »

Random Musings wrote:IMHO, there are two major questions - how do we define "long-term" and will history repeat itself during the defined "long-term" period.

RM
With regards to this discussion, I define "long-term" as 1) Anyone who is investing with the intention of taking an income from their portfolio at some point in the future. 2) Anyone who is currently taking an income from their portfolio.

No one knows if history will repeat itself. There are no guarantees. But given everything we know about asset classes, equities give us the best chance.

Significantly dumbing down a portfolio by reducing equity exposure, you are trading one risk for a worse risk.
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Re: Redefining risk

Post by nisiprius »

Don, I read your posts as saying you think equities are the one best asset class, that all investors should be 100% in equities, and not "dumb down" their portfolio by holding any other asset classes whatsoever. I would appreciate it if you'd confirm that that is indeed what you're saying.
Don Lawson wrote:With this in mind, all asset classes BUT equities are extremely risky.
One more spin of the old broken record, but it's Benjamin Graham, not me, on that record: "On this point we can be categorical. There is no close time connection between inflationary (or deflationary) conditions and the movement of common-stock earnings and prices."

Stocks are not an inflation-tracker. And they are not a hedge against inflation if "hedge" is interpreted to mean something that will act as insurance and reliably spike specifically during periods of high inflation, yielding returns much higher than inflation during those times. What they are is an investment with a good balance of risk and return that has a pretty good record of having a positive real return in the "long run." The question is how long that run is. In the United States, so far, the longest period of zero real return for stocks has been 1966-1982 inclusive, 17 years, not bad. In Japan, people who invested circa 1990 are still waiting for that positive real return.
When long-term investors add ... even bonds to their portfolio they are hurting their chances of overcoming this risk.
The mysterious "TIPS blindness" strikes again. TIPS are not the key to life, the universe, and everything, but with regard to erosion of purchasing power over the long term to say they are "extremely risky" is an overstatement.
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Post by nisiprius »

In this connection, going past the cover to read the actual Newsweek article on The Death of Equities makes interesting reading.

The subtitle is "How inflation is destroying the stock market."
The one rule whose demise did the stock market in could be summed up thus: By buying stocks, investors could beat inflation. Stocks were a reasonable hedge when inflation was low. But they proved helpless against the awesome inflation of the past decade....

There are at least four good reasons why inflation is killing equities:

• Stock prices reflect anticipated corporate profits. During periods of rapid inflation, however, profits fall because most businesses cannot raise prices quickly enough to keep up with costs.

• Even gains in profits are largely illusory because inflation makes them look rosier than they actually are. And because plant and equipment are depreciated at historic cost rather than replacement price, money that should go into capital investing and inventory purchasing instead goes to the government in taxes.

• Experience has taught investors that inflation will lead to an economic downturn that will wreck corporate profitability and stock prices. This happened in 1974, when the worst recession since the Depression followed the last burst of double-digit inflation.

• Investors jump from stocks to bonds to nail down high rates. Inflation also promtps corporations to sell debt because it is tax-deductible and can be paid off in cheaper dollars—thereby reducing the flow of new stocks to market.
After inflation eased off, the stock market took off, and "The Death of Equities" became a laughingstock.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
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Re: Redefining risk

Post by Don Lawson »

nisiprius wrote:Don, I read your posts as saying you think equities are the one best asset class, that all investors should be 100% in equities, and not "dumb down" their portfolio by holding any other asset classes whatsoever. I would appreciate it if you'd confirm that that is indeed what you're saying.
That is exactly what I'm saying. If investors have the emotional fortitude (most don't) to stomach the extreme volatility and are either saving for retirement, or currently taking a retirement income in a systematic way, 100% equity portfolio provides the best means to overcome my definition of risk. If you don't have the same definition as me, or the stomach to continue with withdraw plans during a down market, this is a not a good strategy.

As far as a "close time" connection or correlation between equity prices and inflation... I'm not arguing that there is one. Remember, we are speaking in reference to the long-term investor where anything "close time" doesn't really matter.

With regard to TIPS, while purchasing power is clearly preserved, one would need a massive portfolio relative to the amount of income they plan on taking if they want to grow their purchasing power and take an income. This is either unattainable for some people or would push their retirement years back unnecessarily while they grow their portfolio. I don't think this is a good long term strategy.

Nisiprius, you have a fantastic argument about Japan and even the 17 year period from 1966-1982, however, I'm curious what the data would suggest if measured using a truly diversified portfolio of equities (in light of the 3-factor model) not just the DOW, S&P500, or the Nikkei 225. Do you know how the numbers would look?
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Re: Redefining risk

Post by GregLee »

nisiprius wrote: Stocks are not an inflation-tracker. And they are not a hedge against inflation if "hedge" is interpreted to mean something that will act as insurance and reliably spike specifically during periods of high inflation, yielding returns much higher than inflation during those times. What they are is an investment with a good balance of risk and return that has a pretty good record of having a positive real return in the "long run." The question is how long that run is. In the United States, so far, the longest period of zero real return for stocks has been 1966-1982 inclusive, 17 years, not bad.
You offer three supposed paraphrases of the original assertion then argue that the positions of your paraphrases are wrong. This is not a good way to argue when the paraphrases are so inaccurate. To say that stocks give the best protection against inflation risk is not to say they track inflation, not to say they are hedges in the sense you define that, and not to say they offer real returns in the long run.

The argument that TIPS give better inflation protection than stocks, on the other hand, makes sense.
Greg, retired 8/10.
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Post by TrustNoOne »

I guess everyone can define risk they way they like.

Here's analysis I did using the model on Bob's Financial Website. Shows the trailing 30 year SWR for a 100% Matress (i.e. return = 0), 100% Stocks and 100% Bond portfolio. So the 1955 data represents the period 1926-1955. The SWR is what would have worked for that period.

Some interesting conclusions. The 30 year trailing SWR minimum (which is what is used for the various recomendations) was in the late 90's for stocks at around 4%. This was also the period where the 30 year geometric mean inflation was the highest. Conclusion - stocks are not particularly immune to inflation, and higher inflation is not good for a stock based distribution portfolio. Stocks suffer under inflation just like anything else.

MUM - Money Under Matress SWR was my own invention - just to see what you really gain by investing. The worst 30 year SWR was 1.19%. Not very attractive, but it at least puts a floor on SWR. It was also the worst in the highest inflation periods, as would make sense.

Also interesting is the worst SWR for 100% bonds was not in the high inflation era (late 90's when bonds produced 30 year SWR's as good as stocks) but rather in the 30 years ending in the 70's - a period marked by negative real interest reates, esp. in the early years. Sound familiar?

I'd rather put in a graph than a hard to read table, but I never can make that work. Is there a trick I need to know?

30 Yr Pr. Inflation MUM S SWR B SWR
1955 1.35% 3.2% 7.8% 5.6%
1956 1.49% 3.1% 7.4% 5.4%
1957 1.66% 3.0% 5.5% 5.1%
1958 1.76% 2.9% 3.9% 5.0%
1959 1.80% 2.8% 4.4% 4.8%
1960 2.07% 2.6% 5.8% 4.3%
1961 2.43% 2.3% 10.2% 4.0%
1962 2.84% 2.0% 11.0% 3.3%
1963 2.87% 2.0% 7.8% 3.2%
1964 2.85% 1.9% 8.6% 3.0%
1965 2.82% 2.0% 6.4% 2.9%
1966 2.89% 1.9% 5.0% 2.8%
1967 2.89% 1.9% 8.6% 2.9%
1968 3.15% 1.8% 6.8% 2.6%
1969 3.35% 1.8% 7.3% 2.5%
1970 3.52% 1.7% 8.8% 2.4%
1971 3.30% 1.8% 12.2% 2.6%
1972 3.12% 2.0% 12.3% 2.8%
1973 3.31% 1.9% 11.1% 2.8%
1974 3.63% 1.9% 10.3% 2.8%
1975 3.78% 1.9% 8.2% 2.8%
1976 3.38% 2.1% 11.7% 3.3%
1977 3.31% 2.2% 13.5% 3.5%
1978 3.50% 2.2% 14.8% 3.6%
1979 4.01% 2.1% 13.7% 3.4%
1980 4.22% 2.1% 12.1% 3.6%
1981 4.31% 2.1% 11.3% 3.8%
1982 4.41% 2.0% 10.4% 3.8%
1983 4.52% 1.9% 11.6% 3.7%
1984 4.68% 1.8% 8.0% 3.6%
1985 4.79% 1.7% 6.4% 3.7%
1986 4.73% 1.7% 6.4% 3.9%
1987 4.78% 1.6% 7.9% 3.8%
1988 4.87% 1.6% 5.9% 4.0%
1989 4.97% 1.5% 5.5% 4.2%
1990 5.12% 1.5% 5.8% 3.8%
1991 5.21% 1.4% 4.8% 3.9%
1992 5.26% 1.3% 5.6% 3.8%
1993 5.30% 1.3% 4.8% 3.9%
1994 5.36% 1.3% 4.3% 3.8%
1995 5.38% 1.2% 4.0% 3.9%
1996 5.37% 1.2% 4.8% 4.0%
1997 5.33% 1.2% 4.1% 4.2%
1998 5.22% 1.2% 4.0% 4.3%
1999 5.10% 1.2% 4.8% 4.7%
2000 5.03% 1.2% 5.1% 4.4%
2001 4.97% 1.2% 4.8% 4.3%
2002 4.94% 1.2% 4.4% 4.3%
2003 4.71% 1.3% 5.8% 4.6%
2004 4.42% 1.4% 9.7% 5.1%
2005 4.31% 1.4% 8.1% 5.2%
2006 4.23% 1.4% 7.3% 5.0%
2007 4.14% 1.5% 9.1% 5.4%
2008 3.84% 1.5% 10.2% 6.0%
2009 3.51% 1.7% 10.6% 6.8%
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Don Lawson
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Post by Don Lawson »

TrustNoOne wrote:I guess everyone can define risk they way they like.
Loss of purchasing power over time is not just a random definition of risk. It is the primary concern when constructing a portfolio. People overlook this. The same way people overestimate the value/utility of their fixed pensions over their 30 year (or more) retirement. It's easy to point to extreme volatility, decade long downturns, and a poor economy when justifying a 50/50 portfolio which you will use for retirement income for over 30 years.

No one is saying that equities are a one for one hedge against inflation. It's not about correlation. It's about constructing a portfolio that will increase purchasing power over time while still taking distributions. A truly diversified equity portfolio is the best solution I've found to this problem.
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Post by Dick Purcell »

Don –

You’re certainly right to assault the most common misuse of the mighty fear-word risk in investment. But the principal culprit is not long-term investors – it’s the “investment” courses in the universities. Whistles and cheers for your assault on that.

But your definition isn’t best either. It’s a sunk cost view.

The best is Taylor’s common-sense, investment-purpose-focused definition:

Risk is shortfall danger for the investor’s future financial needs and goals.

Dick Purcell
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Post by Don Lawson »

Dick Purcell wrote:Don –

You’re certainly right to assault the most common misuse of the mighty fear-word risk in investment. But the principal culprit is not long-term investors – it’s the “investment” courses in the universities. Whistles and cheers for your assault on that.

But your definition isn’t best either. It’s a sunk cost view.

The best is Taylor’s common-sense, investment-purpose-focused definition:

Risk is shortfall danger for the investor’s future financial needs and goals.

Dick Purcell
I like your take although I'm not sure I quite understand what you mean by "sunk cost."

I like Taylor's definition. The best found "cure", if the financial need is long term retirement income, is a passively managed, diversified, equity portfolio through all market cycles and economic climates. Not treasures, not munis, not cd's, not TIPS, not gold, and not real estate. Is there something that gives you a better chance of meeting and exceeding your financial needs in a world where prices rise?
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Re: Redefining risk

Post by Boglenaut »

Don Lawson wrote:Most long-term investors have an incorrect view of risk. They define risk as a loss of principal when the real risk to a long-term investor is the loss of purchasing power over time.
I don't agree with your premise. I believe most long term investers are quite aware of inflation risk.
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Post by ddb »

Don Lawson wrote:
Dick Purcell wrote:Don –

You’re certainly right to assault the most common misuse of the mighty fear-word risk in investment. But the principal culprit is not long-term investors – it’s the “investment” courses in the universities. Whistles and cheers for your assault on that.

But your definition isn’t best either. It’s a sunk cost view.

The best is Taylor’s common-sense, investment-purpose-focused definition:

Risk is shortfall danger for the investor’s future financial needs and goals.

Dick Purcell
I like your take although I'm not sure I quite understand what you mean by "sunk cost."

I like Taylor's definition. The best found "cure", if the financial need is long term retirement income, is a passively managed, diversified, equity portfolio through all market cycles and economic climates. Not treasures, not munis, not cd's, not TIPS, not gold, and not real estate. Is there something that gives you a better chance of meeting and exceeding your financial needs in a world where prices rise?
Depends on what your financial needs are.

If a person's goals and given savings rate require a real return of 5% annually, then yes, stocks probably give the best odds of meeting the goal. Of course, this does not address whether the goal is actually reaonable.

On the other hand, if a person's goals and given savings rate require a real return of 0% annually, then 100% stocks definitely does NOT give the best odds of meeting future goals.

The problem with any financial asset is that none of us know the true expected real rate of return, nor do we know expected variance, nor do we know the expected correlation with other asset classes. Even if we did know, these figures are most likely dynamic, which means that you'll be wrong soon enough.

With all due respect, it is foolish to claim that 100% equity gives the best odds of meeting any goal. This is clearly not true. If I have $100,000 today and my goal is to give $110,000 in five years to a particular charity, what allocation is most appropriate for me?

- DDB
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Post by Don Lawson »

ddb wrote:
With all due respect, it is foolish to claim that 100% equity gives the best odds of meeting any goal. This is clearly not true. If I have $100,000 today and my goal is to give $110,000 in five years to a particular charity, what allocation is most appropriate for me?

- DDB
I don't think 100% equities gives you the best odds of meeting just any financial goal. The financial goal I'm talking about is income through retirement. I am not talking about taking a substantial one-time distribution like you mention.

I argue that if your goal is a long retirement of taking of income from your portfolio and you don't want your money to run out or have it's purchasing power erode (those are the two pitfalls, right?), a diversified 100% equity portfolio provides you with your greatest chance of success.
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Post by magician »

Dick Purcell wrote:The best is Taylor’s common-sense, investment-purpose-focused definition:

Risk is shortfall danger for the investor’s future financial needs and goals.
That depends, of course, on how you define "best", and how you define "shortfall danger".

One problem with using this definition of "risk" is that it doesn't address how to measure it. One might argue that defining how to measure risk is at least as important as defining what risk is.
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Post by Random Musings »

If starting at 100% equities and continued investment into the portfolio, when does need of risk come into play?

RM
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Post by Don Lawson »

ddb wrote: The problem with any financial asset is that none of us know the true expected real rate of return, nor do we know expected variance, nor do we know the expected correlation with other asset classes. Even if we did know, these figures are most likely dynamic, which means that you'll be wrong soon enough.

- DDB
I'm not saying, nor would I ever say, that I know future real rates of return, variance, correlation, or anything else you mention. I think your quote is just avoiding my premise:

Given what we know, a diversified 100% equity portfolio provides us with the greatest CHANCE to accumulate and then distribute income during retirement with the LEAST CHANCE of running out of money or having our purchasing power erode.
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Post by rmelv »

Are you under the impression that bonds and even treasury bills have underperformed inflation?

That's simply not true. To think that a Treasury bond holder is unaware of inflation demonstrates that you have never tried to understand the bond market. Inflation expectations are one of the largest factors in determining the price of a Treasury bond. The market clearing price generally compensates investors for inflationary risks.

100% Equities is really unrealistic. What if you had a million dollars in 2007? How do you know if you are ready to retire? Your portfolio value is so fickle that it is impossible to construct a budget. You don't know if you can afford a penthouse apartment or a trailer.
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Post by Don Lawson »

magician wrote:
One problem with using this definition of "risk" is that it doesn't address how to measure it. One might argue that defining how to measure risk is at least as important as defining what risk is.
Excellent point. It is much easier to define risk than to measure it.
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Post by Don Lawson »

rmelv wrote:Are you under the impression that bonds and even treasury bills have underperformed inflation?

That's simply not true. To think that a Treasury bond holder is unaware of inflation demonstrates that you have never tried to understand the bond market. Inflation expectations are one of the largest factors in determining the price of a Treasury bond. The market clearing price generally compensates investors for inflationary risks.
I understand that treasury bonds have outpaced inflation. I understand that treasury bonds provide good current income with virtually no risk to that income. The problem is that current income is only part of the story. If you take income from a bond portfolio you aren't increasing an asset base over time that can pay you more in the future when costs have risen.

Does anyone know the historical real return on a portfolio of 10 year treasuries?
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Post by Don Lawson »

rmelv wrote:Inflation expectations are one of the largest factors in determining the price of a Treasury bond.
Inflation "expectations" mean nothing to me and shouldn't dictate how I invest.
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Post by ddb »

Don Lawson wrote:
ddb wrote:
With all due respect, it is foolish to claim that 100% equity gives the best odds of meeting any goal. This is clearly not true. If I have $100,000 today and my goal is to give $110,000 in five years to a particular charity, what allocation is most appropriate for me?

- DDB
I don't think 100% equities gives you the best odds of meeting just any financial goal. The financial goal I'm talking about is income through retirement. I am not talking about taking a substantial one-time distribution like you mention.

I argue that if your goal is a long retirement of taking of income from your portfolio and you don't want your money to run out or have it's purchasing power erode (those are the two pitfalls, right?), a diversified 100% equity portfolio provides you with your greatest chance of success.
Sorry, still doesn't make sense.

Let's talk about a long-term retirement, starting next year and lasting for 30 years, with portfolio income needs of $50K per year in real dollars. You say I should be 100% stocks. You also say that lump sum short-term goals are not appropriate for stocks. Agreed. So, pretend that instead of a retirement goal, I have 30 lump sum goals as follows, all in today's dollars:

Code: Select all

Year   Need
 1     $50K
 2     $50K
 3     $50K
 ...     ...
 30    $50K
We established above that a 5-year lump sum goal shouldn't be in stocks. Therefore, my first five goals in this cash flow sequence shouldn't be in stocks either, right? Okay, so in your mind, how many years constitutes "short-term"? For me, that number is at least 10 years, meaning that at least 10 years worth of anticipated withdrawals should be in low-risk investments (cash or high-quality short-term bonds).

So, when you consider a retirement goal as a deconstructed series of individual cash flows, how can you possibly recommend 100% equities?

- DDB
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Re: Redefining risk

Post by nisiprius »

Don Lawson wrote:
nisiprius wrote:Don, I read your posts as saying you think equities are the one best asset class, that all investors should be 100% in equities, and not "dumb down" their portfolio by holding any other asset classes whatsoever. I would appreciate it if you'd confirm that that is indeed what you're saying.
That is exactly what I'm saying. If investors have the emotional fortitude (most don't) to stomach the extreme volatility and are either saving for retirement, or currently taking a retirement income in a systematic way, 100% equity portfolio provides the best means to overcome my definition of risk. If you don't have the same definition as me, or the stomach to continue with withdraw plans during a down market, this is a not a good strategy.

As far as a "close time" connection or correlation between equity prices and inflation... I'm not arguing that there is one. Remember, we are speaking in reference to the long-term investor where anything "close time" doesn't really matter....Nisiprius, you have a fantastic argument about Japan and even the 17 year period from 1966-1982, however, I'm curious what the data would suggest if measured using a truly diversified portfolio of equities (in light of the 3-factor model) not just the DOW, S&P500, or the Nikkei 225. Do you know how the numbers would look?
Well, I have one set of figures at hand. The SBBI data for "small company stocks" shows from 1966 through 1982, inclusive, including reinvested dividends and adjusting for inflation, the total real return over that time period averaged 7.53% CAGR. Versus essentially zero, but very very slightly negative, for "large company stocks."
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Post by rmelv »

Don Lawson wrote:
rmelv wrote:Inflation expectations are one of the largest factors in determining the price of a Treasury bond.
Inflation "expectations" mean nothing to me and shouldn't dictate how I invest.
You seem conscious of the possibilities of inflation. I am merely saying that the bond market is too, and bonds are usually discounted to the point where they offer a positive real yield, unless all of the other alternatives look terrible.
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Post by nisiprius »

Don Lawson wrote:Does anyone know the historical real return on a portfolio of 10 year treasuries?
According to the SBBI 2005 yearbook, for 1926 through 2004 inclusive:

2.8% real for long-term corporate bonds
2.3% real for long-term government bonds (20-year term)
2.3% real for intermediate-term government bonds (5-year term)
0.7% real for Treasury bills

If it was 2.3% real for 20-year and 5-year bonds, I imagine it wasn't too different for 10-year bonds.

However, it should be noted that in all case total returns were supercalifragilistic from 1926 to about 1940, vomitrocious from 1940 to 1980, and splendiferous from 1980 to the present. 1940 to 1980 is a long time.

William J. Bernstein's essay, Only Two Centuries, is worth reading though, because according to him, total returns were:

Code: Select all

         1801-1900    1901-2000
Stocks   6.76%          6.45%
Bonds    5.23%          1.57%
The whole essay, which is short, is worth reading. He concludes:
With hindsight we can see that the 5% stock-bond return gap in the 20th century was the result of a totally unexpected inflationary burst produced by the abandonment of hard money. You can’t abandon hard money twice, so a repeat is not possible. Though inflation might increase dramatically in the future, resulting in another high stock-bond return gap, it’s at least as likely that inflation will remain tame for the foreseeable future, producing nearly equal stock and bond returns. More importantly, we now live in a world where investors have learned to extract an inflation premium from bonds and to expect inflation protection from stocks. This increases expected bond returns and reduces expected stock returns.
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Post by Don Lawson »

ddb wrote:
We established above that a 5-year lump sum goal shouldn't be in stocks. Therefore, my first five goals in this cash flow sequence shouldn't be in stocks either, right? Okay, so in your mind, how many years constitutes "short-term"? For me, that number is at least 10 years, meaning that at least 10 years worth of anticipated withdrawals should be in low-risk investments (cash or high-quality short-term bonds).

So, when you consider a retirement goal as a deconstructed series of individual cash flows, how can you possibly recommend 100% equities?

- DDB
Very logical argument but I still don't buy it.

So lets say that 10 years worth of distributions shouldn't be in equities. Sounds reasonable. So each year you take out 50k from the cash or bond portion of your portfolio. But now you don't have your 10th year in bonds/cash anymore. You have to sell some equities, right? Taking 10% out of the cash/bond portion each year isn't sustainable from that portion of the portfolio. Equities must be sold whether the market is up, down, or sideways. Also, taking out 50k every year you are essentially giving yourself a pay decrease. We're trying to match the 50k purchasing power in year one and every year thereafter.

Why not take out the inflation adjusted 50k every year from equities no matter what the market is doing. Some years that adjusted 50k will be 4% of the portfolio, other years it will be 7%, 9%, 5%, or 2% depending on the market.

Years ago I ran some numbers and I believe they are pretty favorable using this strategy ONLY if your equity portfolio is truly diversified with appropriate international, small cap, and value weightings. Not the US Large Cap heavy portfolios that are all too common. I want to emphasize that I have nothing concrete at this moment to back up my claim in the first sentence of this paragraph.
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Re: Redefining risk

Post by richard »

Don Lawson wrote:With this in mind, all asset classes BUT equities are extremely risky. Equities are the only asset class with a lengthy track record of overcoming this risk. When long-term investors add cash, gold, and even bonds to their portfolio they are hurting their chances of overcoming this risk. And frankly, I'm surprised how easily people lose sight of this.
If markets are at all efficient, it can not be the case that one asset class has significantly higher risk adjusted expected returns than another asset class, where risk is defined however the market defines risk. If one asset class had significantly higher risk adjusted returns, investor would buy more of it, increasing price until its risk adjusted return came down.

The Bill Bernstein quote Nisi posted above is an example "More importantly, we now live in a world where investors have learned to extract an inflation premium from bonds and to expect inflation protection from stocks. This increases expected bond returns and reduces expected stock returns." Investors, seeing higher stock returns, move from bonds to stocks, which helps equalize returns.

If your definition of risk is different from the market's, you could do better. But it can't be the case that everyone is different from the average in the same direction (Lake Woebegon).
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Re: Redefining risk

Post by Don Lawson »

richard wrote: If markets are at all efficient, it can not be the case that one asset class has significantly higher risk adjusted expected returns than another asset class, where risk is defined however the market defines risk. If one asset class had significantly higher risk adjusted returns, investor would buy more of it, increasing price until its risk adjusted return came down.
That quote makes sense on one level... there is no asset class that provides us with a premium risk adjusted return. There is no free lunch. It really is all about risk/return. Historically, equity investors have been compensated more than bond investors for taking on a higher perceived risk.

Additionally, this why you could argue that expected returns during times of economic difficulty (now) are higher in order to induce investors into taking on the higher perceived risk.

I think your point is a good one, but my definition of risk is meant only to relate to one very specific goal of inflation protected retirement income, not overall market risk and volatility.
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Re: Redefining risk

Post by Don Lawson »

richard wrote:
The Bill Bernstein quote Nisi posted above is an example "More importantly, we now live in a world where investors have learned to extract an inflation premium from bonds and to expect inflation protection from stocks. This increases expected bond returns and reduces expected stock returns." Investors, seeing higher stock returns, move from bonds to stocks, which helps equalize returns.
I'm not sure when we moved to this new world...

I think the market consensus is that stocks are much more volatile (risky) than bonds. I agree and that's why I think investors will be compensated for taking on this type of risk.

I'd be curious to know the date of that quote.
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Post by cjking »

rmelv wrote:100% Equities is really unrealistic. What if you had a million dollars in 2007? How do you know if you are ready to retire? Your portfolio value is so fickle that it is impossible to construct a budget. You don't know if you can afford a penthouse apartment or a trailer.
My view is that "you had a million dollars" is not the right way to measure where you are. PE10 peaked at 27.31 in 2007, if contemplating retiring with a 100% equity portfolio at that peak I would have said "I have $30,000 a year of income". ($1 million * 83% / 27.31 = $30,000.) That income would be a current upper bound on what I thought was safe, it might fluctuate up or down in subsequent years, but probably not by very much.

Depending on age, it might be possible to get more than that from an inflation-linked annuity.
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Post by thewatcher »

Don Lawson wrote;
I think the market consensus is that stocks are much more volatile (risky) than bonds. I agree and that's why I think investors will be compensated for taking on this type of risk.
Pretty much with you all the way DL. The risk thing is very time-dependent with equities and reduces the longer you hold them. So if you are talking about holding a portfolio indefinitely up until and through retirement then 100% equities seems reasonable. Pretty close to my own plans to be honest.

One factor that I don't think has been mentioned but seems pertinent is dividend income. Long-term studies (Dimson) have shown that this has kept it's nose marginally ahead of inflation long-term and is also a lot less volatile than capital values. If you have a sufficiently large equity portfolio to live entirely on the dividend income then this would massively strengthen the case for 100% equities because you don't need to worry about the more volatile size of your pot.

Contrast this with taking the income from a bond portfolio where there is zero rise over time (your 4% bond pays 4% of the original capital until the bond matures). So basically your income will fall in real terms as inflation erodes its value or you will need to gradually sell down the principle to compensate (the ideal with taking divi income from shares is that you never sell the underlying).

So historically you have equity divis keeping pace with inflation vs bond income being steadily eroded by it. The amount of income you can take from TIPS without reducing the real value of your portfolio is of course derisory and you'd need to be massively wealthier than someone taking similar equity income not to suffer this. Again, it's just a case of ignoring the volatility of an equity portfolio. And hoping history proves a reasonable guide to the future.

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Post by ddb »

Don Lawson wrote:Very logical argument but I still don't buy it.
Don Lawson wrote:I want to emphasize that I have nothing concrete at this moment to back up my claim in the first sentence of this paragraph.
Sounds like you don't have anything concrete to back up your position at all, and you freely admit that you don't buy into logic. So...I'm not sure you're going to get very far convincing people that you are right.

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Re: Redefining risk

Post by YDNAL »

Don Lawson wrote:Most long-term investors have an incorrect view of risk. They define risk as a loss of principal when the real risk to a long-term investor is the loss of purchasing power over time.
Don Lawson wrote:
nisiprius wrote:Don, I read your posts as saying you think equities are the one best asset class, that all investors should be 100% in equities, and not "dumb down" their portfolio by holding any other asset classes whatsoever. I would appreciate it if you'd confirm that that is indeed what you're saying.
That is exactly what I'm saying. If investors have the emotional fortitude (most don't) to stomach the extreme volatility and are either saving for retirement, or currently taking a retirement income in a systematic way, 100% equity portfolio provides the best means to overcome my definition of risk.
Your definition of risk ignores that you think you have $100 to buy groceries (inflated prices, of course) and the market decides you only have $50 and your family goes hungry. Now, that's real risk.
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Post by Dick Purcell »

Don --

I like that you like that I like Taylor's purpose-focused definition of risk --

Risk is shortfall danger for the investor’s future financial needs and goals.

I take back my "sunk cost" sentence. I was interpreting your inflation focus too narrowly, thinking you are concerned only with protecting what you now have, which for most people is not enough for the future. But it remains true that while inflation is a major consideration, it ain't the only consideration in pursuit of the investor's future-needs-and-goals purpose.

Regarding your advocacy of 100% stocks, in other threads there's a LOTTA evidence conflicting with that allocation. EG, in one very long thread on update of the Trinity study, thread started by Wade maybe two months ago (?), lots of Monte Carlo showed the widely parroted 30-years 4% "safe" withdrawal rate is safest at about 40% stocks.

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Post by Dick Purcell »

Magician !

Yes, in that common-sense purpose-focused definition of risk from Taylor that I quoted and advocated, measurement of that risk sure is a challenge.

(When I quoted that definition of risk, I should have cited and credited your refinement of it back when Taylor offered it -- your pointing out that it includes both probabilities and magnitudes of shortfall.)

Of course, to get there we first have to deal with uncertainties of the underlying assumptions. But let's pretend we've solved that one and want to deal with your probabilities-and-magnitudes point.

What I would not do is try to measure and express it in some sort of "higher" math, such as integration to measure the probability-magnitude area, or dream up some "utility function," which I'm sure is the kind of thing the boys up in the "investment education" ivory tower would want to do.

Instead, I want to communicate it to the investor, so he can understand it. I'd use graphs carefully designed for this kind of communication.

If he understands it -- the probabilities and magnitudes of shortfall -- he may then increase his pre-retirement investments, or reduce his annual retirement budget, or decide against the yacht. He may choose an investment with greater probability of shortfall but lesser magnitudes of potential shortfalls.

It's his life, his priorities. I think my duty is to inform him as well as I can, so he can judge and apply his priorities to his life.

Speaking of shortfalls, I think the critical shortfall of the boys up in that investment education ivory tower is that they DE-communicate. Put it in math the investors does not understand. Wrap it in labels so misleading it appears the labels were chosen to mislead.

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Last edited by Dick Purcell on Tue Aug 23, 2011 5:11 pm, edited 1 time in total.
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Post by magician »

Dick Purcell wrote:What I would not do is try to measure and express it in some sort of "higher" math, such as integration to measure the probability-magnitude area, or dream up some "utility function," which I'm sure is the kind of thing the boys up in the "investment education" ivory tower would want to do.

Instead, I want to communicate it to the investor, so he can understand it. I'd use graphs carefully designed for this kind of communication.l
I don't see these as mutually exclusive. I think that it's perfectly fine to use higher math - calculus, for example - and utility functions (note: these do not measure risk; they measure how a particular investor feels about risk and return in combination), as long as . . . here's the kicker . . . they help the investor to understand how risk affects him.
Dick Purcell wrote:Speaking of shortfalls, I think the critical shortfall of the boys up in that investment education ivory tower is that they DE-communicate. Put it in math the investors does not understand. Wrap it in labels so misleading it appears the labels were shosen to mislead.
I'm one of those educators. I certainly don't choose labels with the intent to mislead investors. I try to ensure that the average investor understands how risk and return both affect his ultimate goals, and I also educate investment professionals; I don't see those as being in conflict at all.

In short, I take my signature to heart. Please don't paint all finance educators with the same broad brush.
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Re: Redefining risk

Post by magician »

Don Lawson wrote:Most long-term investors have an incorrect view of risk. They define risk as a loss of principal when the real risk to a long-term investor is the loss of purchasing power over time.
I teach an online course in Asset Allocation at UCI.

One of the discussion topics I have asks the students how they define risk, and I insist that they get very detailed in their definitions. (For example, if someone were to say that risk is the probability of loss of principal, I will ask them if they really mean that risk is a real number between zero and one.) The answers, ultimately, are very, very interesting. According to the students, this is the single, most helpful discussion topic in the course.

I have not found that most of these students define risk as a loss of principal; indeed, I have not found that most of these students (nearly all of whom are long-term investors) agree on any particular definition of risk. So, while I may believe your thesis that most long-term investors have an incorrect view of risk (if you include under the rubric of "incorrect view" having no well-defined view at all), I do not believe that they define risk as a loss of principal.
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Re: Redefining risk

Post by nisiprius »

Don Lawson wrote:I'd be curious to know the date of that quote.
Then why didn't you click on the link I provided? Here is is again:
William J. Bernstein's essay, Only Two Centuries, is worth reading...
I could give you the answer, but I'd rather just give you the link because it's a really good essay and and it's worth reading. It's short. The copyright date is at the bottom. Don't peek.
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Post by bobcat2 »

Risk is uncertainty that is consequential. Therefore uncertainty is a necessary but not a sufficient condition for risk. Every risky situation is uncertain, but there can be uncertainty without risk. So in finance risk is uncertainty (or variability) of asset returns.

Here's how Krugman puts it.
Risk - the variability (or unpredictability) an asset contributes to a saver's real wealth.

Here's how Merton puts it.
Risk is uncertainty that "matters" because it affects people's welfare.


And here is how Sharpe puts it.
Risk is the uncertainty associated with the end-of-period value of an investment in either a single asset or a portfolio of assets.

All three Nobel Laureates are giving in their own words the standard definition of risk in economics and in particular financial economics. It's true that some people put forward other definitions, but this is the standard definition in economics. This is pretty straightforward stuff. It's hard to fathom why there is so much confusion about this. :roll:

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Post by magician »

bobcat2 wrote:Risk is uncertainty that is consequential. Therefore uncertainty is a necessary but not a sufficient condition for risk. Every risky situation is uncertain, but there can be uncertainty without risk. So in finance risk is uncertainty (or variability) of asset returns.

Here's how Krugman puts it.
Risk - the variability (or unpredictability) an asset contributes to a saver's real wealth.

Here's how Merton puts it.
Risk is uncertainty that "matters" because it affects people's welfare.


And here is how Sharpe puts it.
Risk is the uncertainty associated with the end-of-period value of an investment in either a single asset or a portfolio of assets.

All three Nobel Laureates are giving in their own words the standard definition of risk in economics and in particular financial economics. It's true that some people put forward other definitions, but this is the standard definition in economics. This is pretty straightforward stuff. It's hard to fathom why there is so much confusion about this. :roll:

BobK
At the moment I'm consulting on project risk management for a large construction project.

The "standard" definition of project risk (i.e., the definition appears in the Project Management Institute's Project Management Body of Knowledge (PMBOK® Guide)) is:

Risk: An uncertain event or condition that, if it occurs, has a positive or negative effect on a project's objectives.

(Note how well this fits with your first sentence.)

Nevertheless, you have risk managers who, for example, insist that "risk" only encompasses events that have a negative effect (and use some other word, like "opportunity" for uncertain events that have a positive effect).

There's confusion because "risk" means different things to different people; many of them reject the "standard" definition in favor of one that feels better for them. Trying to insist that everyone use the standard definition frequently turns out to be a fool's errand.

I underlined the sentence you wrote that is at the heart of the disagreement. Your first sentence may find general agreement, but that doesn't necessarily mean that the one I underlined is the logical conclusion.
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Post by bobcat2 »

Hi magician,

I certainly agree that the focus of risk management should be on the uncertainty that has negative consequences, but that doesn't strike me as inconsistent with the standard economics definition of risk.

Obviously at least some people will want to define risk differently. My point is that in economics in general and financial economics in particular there is a standard definition of risk and people ought to be aware of that. When an economist reads something written by another economist who is writing about risk, that reader knows what the writer means by risk. If there is some non-standard meaning for risk in the prose the writer will state that. For example, if Frank Knight's definition of risk is being used, the prose will say 'Knightian risk' and not risk.

BobK
In finance risk is defined as uncertainty that is consequential (nontrivial). | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.
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Post by Rick S »

Risk as borrowed from Military Strategy is the disagreement between ends, ways, and means. It's that big gap that exists between what you want to happen in the future and the methods and resources at your disposal.

Risk pops up all over in ways that you'll never predict. Thus, it's good to have alternatives (B.H. Liddell Hart) or overwelming resources (Sun Tzu).

Is there a thread that lists generic risks? I can't find it.
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Post by Dick Purcell »

BobK --

My Bodie textbook has 10^9 repetitions of the label "risk" that are inconsistent with those definitions you quoted. These 10^9 misuses of the word refer only to return-rate standard deviation. Nothing about wealth, or value, or whether it matters in people's welfare.

Does not address $. Does not address when $ may be needed.

Doesn't even pass the grade school test of common sense. Measures deviation without specifying what is deviated from. According to this pinhead use of the term, a 10%-mean investment with 2% standard deviation has the same "risk" as a 1%-mean investment with 2% standard deviation.

If those guys want to babble to each other this way, up in their ivory tower, that's their privilege. But we have 100 million Americans down on earth whose futures depend on this stuff. We need investment educators who can speak purpose-focused common sense in people-ese. I nominate Professor Taylor.

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Post by magician »

bobcat2 wrote:Hi magician,

I certainly agree that the focus of risk management should be on the uncertainty that has negative consequences, but that doesn't strike me as inconsistent with the standard economics definition of risk.
Howdy.

Nor does it strike me that way. I take the view that (project) risk encompasses both positive and negative effects because I believe that it simplifies the language, and I choose to believe that the managers with whom I work are smart enough to know the difference, and to know that the response to a negative risk should be different from the response to a positive risk.
bobcat2 wrote:My point is that in economics in general and financial economics in particular there is a standard definition of risk and people ought to be aware of that. When an economist reads something written by another economist who is writing about risk, that reader knows what the writer means by risk.
I couldn't agree more. I'm a mathematician by education, so I am acutely aware of the necessity of terms being well-defined.
bobcat2 wrote:If there is some non-standard meaning for risk in the prose the writer will state that. For example, if Frank Knight's definition of risk is being used, the prose will say 'Knightian risk' and not risk.
I agree.

The problem - which is the point that Dick Purcell emphasizes - is that there are a lot of people who are affected by finance who do not know the standard definition of risk and, if they did know it, would not find that it agrees with their internal notion of risk and . . . here's the crux of the problem . . . those who do know the standard definition have to communicate effectively with those who don't.

You and I may know the difference between, say, an increasing function and a strictly increasing function, but we still have to convey that distinction to a first grader who, frankly, isn't all that interested in mathematics in general, much less its subtleties.
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Post by magician »

Dick Purcell wrote:My Bodie textbook has 10^9 repetitions of the label "risk" that are inconsistent with those definitions you quoted. These 10^9 misuses of the word refer only to return-rate standard deviation.
They are, however, consistent with the sentence I underlined. That's why I underlined it.

You should throw away your Bodie textbook. It seems to be nothing more than a source of irritation to you. And it's heavy, to boot.

;)
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Post by Dick Purcell »

Magician --

But I need my Bodie book. It plays a leading role in my novel.

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Post by magician »

Dick Purcell wrote:Magician --

But I need my Bodie book. It plays a leading role in my novel.

Dick Purcell
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Post by bobcat2 »

The confusion about the meaning of risk often appears to come from either confusing the definition of risk with particular risks, or confusing the definition of risk with measures of risk.

The OP of this thread is an example of confusing particular risks with the definition of risk.
Most long-term investors have an incorrect view of risk. They define risk as a loss of principal when the real risk to a long-term investor is the loss of purchasing power over time.
These may be very important investment risks, but they are not definitions of risk.

Dick Purcell appears to be making the latter mistake when he writes about SD (volatility) in the Bodie text. Standard deviation (volatility) is measure of investment risk. It is not a definition of risk. This second mistake is quite common. Below I link to a Larry Swedroe article where he confuses the standard deviation measure of risk with the definition of risk. The article begins with the following.
Risk: What Exactly Is It?

Since none of us can clearly see into the future, achieving an accurate assessment of risk and its related expected returns is a cornerstone of prudent investing. But first it is important to define what exactly is meant by “risk.” Risk takes on many guises and can be different things to different people.

The most commonly used academic definition of risk is standard deviation — a measure of volatility.
BTW I found this article by reading thru the links at the Boglehead Wiki on the topic of risk definitions. :)
http://www.indexfunds.com/articles/20030808_Risk.htm

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Post by dbr »

magician wrote: The problem - which is the point that Dick Purcell emphasizes - is that there are a lot of people who are affected by finance who do not know the standard definition of risk and, if they did know it, would not find that it agrees with their internal notion of risk and . . . here's the crux of the problem . . . those who do know the standard definition have to communicate effectively with those who don't.
Excellent points by both magician and bobcat, but pertaining to the above, it behooves anyone who wants to learn from those who know that an effort be made to understand the terminology. Often that requires beginning with more elementary explanations. Now, I will agree that specialists writing for non-specialists should consider their audience if they want to be effective.
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Post by pkcrafter »

Don Lawson wrote:
Most long-term investors have an incorrect view of risk. They define risk as a loss of principal when the real risk to a long-term investor is the loss of purchasing power over time.
Loss of principal is a risk: loss of purchasing power is also a risk. Dismissing the first definition and only looking at the second seems to me to be rather short-sighted.

Standard deviation is a measure of risk that isn't very useful to average investors. The point is there are several definitions of risk, and which one is used properly depends on the target audience.


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When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.
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