Understanding Stock Market Risk – My Road to Financial Independence Series

 

Life has been a bit of a whirlwind recently. As I mentioned previously, our family had our 3rd child in November which coincidentally was the time of my last post! I failed to mention we also moved into a new house and then had plenty of family and friends visiting as well. We knew this was going to be our last child, so I have really tried to take as much quality time with our little boy as possible and soak up the cuteness of the baby stage. At the same time, I often wish I could be more prolific in my writing,but it seems to really come in fits and spurts. After the clarity of the new tax changes were announced (as a side note these are overall much better changes and I will do a post to summarize this soon), it got my creative juices flowing again to revisit the finance world.

I spent some time figuring out how to engage a group of intelligent professionals who have access to numerous blogs and financial advisors at their disposal. As previously discussed, THE fundamental part of achieving your financial freedom and success will be high levels of saving and allowing a long time for savings to compound. Once these behaviours have been optimized, the final piece of the puzzle is achieving the best possible long term investing returns. There is so much content on the internet about this topic, I concluded there is no way to appropriately do it justice in a didactic lesson type post.

A friend suggested the best way to explain my investment belief system is to show the path from financial newbie to taking the role of sole advisor for our family wealth. He felt showing all the good decisions along with the ignorant mistakes will make readers realize that independent financial decision making is accessible to everyone with the appropriate time dedication. I decided the blend of story and finance will make the information a bit easier to digest and hopefully motivate the high income earning professional to believe your financial freedom is well within your grasp. This multi-post Road to Financial Independence series will balance some introductory concepts, definitions and more advanced investing concepts all together to have something for all readers. Somewhere in between I will dive deeper into the active versus passive investing debate.

It Was the Best of Times, It was The Worst of Times 

My early introduction to investing was buying some RBC Mutual funds in my teenage years at my father’s suggestion. His advisor was gracious with his time and educated me on the power of long term compound growth. During my medical school years my primary focus was keeping debt low and I spent very little time on reading about investing.

My wife and I moved to Victoria, BC in 2007 for medical residency. In late 2008, a very interesting event occurred that had great influence over our financial future. The massive market crash from the Great Financial Crises during 2008-2009 opened my eyes greatly to the world of investing and psychology. The unfortunate pain felt by a number of professionals who were years away from retirement ended up being an incredible opportunity for me to learn from the mistakes of others.

“My advisor should have known better and had me in cash before this meltdown occurred.”

“Dr X only lost 15% of his portfolio, I think I’m going to move to his investment advisor”

“Stocks are useless, I’m taking everything out and putting it in Victoria Real Estate which is so much safer”

“Gold is on a tear now. I think we can make up some of retirement portfolio by putting a solid chunk of cash into it”

The recurring theme of all the discussion around me in the OR’s and the lunch tables was that someone else should have known better and now the doctor was going to take control of their financial affairs. The sheer overconfidence by many of the medical specialists in what the next correct decision would be astounded me. They exhibited very little sound financial knowledge and often each doctor was making conflicting, irrational decisions compared to the previous doctor I had worked with.

In the non-medical world, any friends I had in business would comment on how medical professionals get sought out by the financial industry for their tendency to have excessive disposable income and little financial knowledge. I was determined not to fall into that category. My view was that medicine would be my profession while understanding the financial world would be my business. I knew we had the opportunity to save large amounts of money early on and I wanted to minimize indecision, costly advice and financial mistakes. In my opinion, the retained earnings of your corporation should be viewed as your business regardless of whether you place it in passive investments or buy an actual business.

I decided I needed a rational mental framework to evaluate investment planning. The recurring theme I saw in the doctors surrounding me was a complete lack of faith in their investment process. This seemed to be directly attached to a sudden lack of faith in their financial advisor. Most said they had been with them for many years but now had no faith in them after such a large mistake. It was unclear how selecting the next advisor or choosing to make their own decisions would avoid another large mistake in the future.

This led me to the following conclusions:

  1. It would be best if I could come up with my own financial belief system instead of blindly following others. This would allow me to not make rash decisions when unexpected circumstances happen.
  2. I should approach my own financial decisions with a high degree of skepticism. Professionals have a tendency to be over confident when they stray outside their expertise because they are used to being an authority around decision making.
  3. I should strongly evaluate the cost of financial advice and seek methods that are fair and appropriate.
  4. I should understand what stocks are and the reasonable expectations of risk within the stock market. This will hopefully allow me to not panic when unexpected events occur. I will start with discussing this concept first.

Stock Market Risk

The primary concern regarding risk in the stock market should be:

1) How much the prices can swing up and down both on a daily and yearly basis? This is important to know if you can handle this variation psychologically and not make behavioral mistakes.

2) What is the lowest potential return over a 10-30 year time frame for stocks when compared to other asset classes? This is important to know as the primary risk that exists in investment/retirement planning is to not have adequate growth in your savings to achieve retirement.

I had read in multiple places that the long term inflation adjusted returns for stocks were in the 6-8% range as long as they are held for long periods. This left me somewhat dissatisfied as most medical professionals seemed to know this fact, but they were still running for the hills during the Great Financial Crises. Blind belief systems work well until there is an anomaly event that causes you to re-evaluate. Luckily after searching through the financial literature, I found a book that helped form a core of my financial belief system.

Stocks For The Long Run

The best source I found to get an educated opinion on how stocks can be expected to perform was a classic book by Wharton professor Jeremy Siegel called Stocks For the Long Run. IMHO, this book is required reading for anyone doing DIY investing. This book has been in print for a number of years and attempts to draw out reasonable expectations for how stocks have behaved within the US stock market.

I previously referenced that developing your own financial belief system is essential to avoid the psychological and behavioural investing mistakes that are built into our human nature. Our hard-wired instinctual fear/flight response will take over unless a solid, rational framework allows our slow thinking mind to take over and produce optimal results. This is well represented in Daniel Kahneman’s research that I mentioned previously. Siegel’s work sets the rational framework that all DIY investors should operate from and has significantly influenced my approach to investing.

Before discussing its results, I want to mention a few inherent biases of this study:

  1. it is evaluating the most productive economy (the US) in the world for the 20th century with a significant tailwind of growth. It can’t be extrapolated to every international stock market index for expected returns
  2.  It was weighted to larger market cap companies in the US and therefore can’t be extrapolated to small cap indexes.
  3. It includes both capital appreciation (growth in stock price value) AND dividends (cash flow received from the company) to state a stock’s total market return/year. Some people will view an index and see it went from a price of $1000 to $1100 in 1 year and assume it was a 10% return. Yet often large companies are paying regular dividends which are received by anyone owning them individually or via an index. If the average dividend yield of that index for the year was 2% then the return would be 10% capital appreciation + 2% dividend yield = 12% real return. This book assumes you always re-invest the dividend component to purchase further shares. I believe this concept of a Dividend Re-Investment Plan (DRIP) makes sense to utilize for most investors focusing on building a nest egg and therefore is an accurate presentation of real stock market returns.
  4.  For the majority of historical time evaluated, it would not have been actually possible to purchase the S+P 500 index directly via an index fund and commissions would have been prohibitively high to purchase all 500 companies in a small number of shares each. I would estimate that this bias may skew in favor of suppressing stock prices as it was harder to buy a stock index than it is now. If the average lay investor had an easier method of diversified investing in the 1800’s, they may have had more savings in the stock market.

Real Asset Returns

The following is the results of the real and nominal compounding returns ( Compound Annual Growth Rate or CAGR for short)  of multiple different asset classes from 1802-2012:

  • Stocks: 6.6%(real), 8.1%( nominal)
  • Bonds: 3.6%(real), 5.1%(nominal)
  • US Gov’t T-Bills: 2.7%(real), 4.2(nominal)
  • Gold: 0.7%(real), 2.1%(nominal)
  • US Dollar: -1.4%(real), 1.4%(nominal)
  • Canadian Real Estate 3.9% (real), 5.4% (nominal) *I have added this dataset for comparison purposes as it wasn’t in Prof. Siegel’s work. It does not include “positive cash flow” from investment properties – just capital appreciation.

 A nominal return is what the calculated return is while the real return is the actual purchasing power return MINUS inflation. You can recall from the Why We Invest post that inflation is constantly eroding the purchasing power of your investments.

Gold is typically thought of as an asset to hold during times of stock market volatility or if inflationary forces are about to go rampant when fiat currency (government backed money) is being pumped into the economic system. This leads to lower purchasing power of fiat currency since there are more dollars around to spend. Gold is considered to have a finite physical amount and its price would go up in an inflationary environment. These stats show that it actually barely keeps up with inflation if held for the long term. I choose to hold no gold exposure based on these results.

Gov’t T-Bills would be the US treasury bonds that are considered the safest type of bond available and is often called the risk-free rate (as discussed in the Bonds post). It will generate a lower overall return than other corporate or riskier developing nation bonds that have real potential risk of default or non-repayment. Consider a Canadian government bond rate to be equivalent.

Cash performed quite poorly at a negative return when inflation is considered. Remember the inflation analogy of the rats eating Pablo Escobar’s hidden cash?

The important take away point from this table is the superior 3% real return for stocks comparatively to the next best major asset class. These stock returns factor in the Great Depression and The Great Financial Crises among multiple other volatile price declines of the stock market. In the short term, a stock is the most volatile/ “risky” asset class, but in the long run it becomes the least volatile way to protect your wealth from inflationary forces.

I have discussed previously how a small amount of improved return can lead to dramatic differences in final portfolio amount when compound growth is considered. A 3% difference over a 30 year time horizon on a $100,000 investment leads to a 230% higher final amount for stocks (~$1 million) than bonds ($445K). Assuming you believe that stocks will do better, can you withstand the volatility?

Stock Market Volatility

How long does your time frame need to be in order to ensure the stock market volatility won’t leave you with a smaller real return than bonds? Prof Siegel has shown this via the following stats evaluating the same time period and the likelihood of stocks outperforming bonds:

  • Over 1 year: 60%
  • Over 2 years: 60%
  • Over 10 years: 80%
  • Over 20 years:90%
  • Over 30 years: almost 100%

With the appropriate time frame, stocks will consistently be the better strategy for anyone with time on their side. Even investors that started investing in stocks in 1929 when the Great Depression crash happened, their 30 yr period from that start date would have  still outperformed ever other asset class.

This book goes into far greater depth around the long term safety of stocks that is beyond the scope of this post. I still strongly recommend reading it to build the rational framework around a belief in stocks superiority as an asset class. Its analysis is quite in depth, but it leaves you feeling quite confident in the dataset.

Another resource I found helpful was these posts on stock market myths and a quiz that help gauge your risk perception of the stock market. Try taking the quiz from the MDJ blog and reading the explanations here and here for more statistical analysis before reading some of the important points below.

The brief summary of important points from the quiz:

  1. The worst stock market declines since the Great Depression have reached 30-40% in one or consecutive calendar years. It reached a peak of 63% in the Great Depression but still recovered to make it the best asset class if held for the long run (20-30 years).
  2. Prolonged secular “bear” stock markets (which means poor/flat market returns) are rare. The longest period of no growth is 10 yrs.
  3. Market declines take far less time to recover than most people think. 88% of declines recover within 1-2 years
  4. Bear markets don’t happen as frequently as most people think. The average is every 12 years in the US and 9 years in Canada.

 Final Thoughts

My personal greatest lesson from learning about stocks and stock market volatility was the belief that stocks are short term risky but long term safe. I find the more I read on the actual data that exists, the more fundamental that belief system becomes. I have come to the point that I believe it as thoroughly as most scientific theories. It makes evident sense when understanding the reasons for its outperformance and the empiric data all demonstrates it with an adequate time frame. This has allowed me to hold an investment profile that will generate the highest long term returns even if it may have short term volatility.

The difficulty of behavioural finance is that you simply can’t know with any certainty how you will individually react in a unique environment that is on the tail ends of a standard deviation curve. The excitement of excellent returns and the pessimism of poor returns continue to be reproducible despite our knowledge of investment cycles. This dynamic essentially shifts wealth from emotional investors to patient long term investors.  This old MDJ post from just after the Great Financial Crises describes this sentiment well.

The above graphic perfectly re-creates the thought process that all investors go through and the capitulation/agony stage is where the rational framework has to work the hardest to shine through. Most investors will make multiple poor behavioural investing choices along the way as it is human nature. I felt I had some insight into my real risk tolerance prior to investing that helped me “know thyself”. This leads nicely into the next post on basic asset allocation and how my allocation was shaped differently than typical investment recommendations.

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4 comments On Understanding Stock Market Risk – My Road to Financial Independence Series

  • Great post, looking forward to many more! Curious about your current investment strategy, diversification, asset location and tax implications (ie. eligible dividends within corp from Canadian dividend stocks) – which I’m sure you will explain in future posts. Keep up the great work!

    • Hi Phil

      Thanks for the kind feedback! The positive comments help reinforce that there is some value to the blog and motivates me to write more.

      I am also looking forward to writing about all the things you mentioned since they will likely generate the most discussion and I enjoy the topics more.

      I am trying to strike the balance between keeping the posts accessible to the financial newbie but interesting to those with a solid general finance background.

      The result is every post and topic taking a bit longer to express but so far the feedback has been great from all levels of knowledge!

      Cheers
      FFMD

  • Good read. How much of your road to financial freedom do you attribute to starting your major earning phase of your life and investment phase at the start of one of greatest bull markets in history (going on for 9 years now) and at a time when real estate was appreciating at double digit growths in the Toronto and Vancouver area. Do you think your advice would be any different to someone starting their investment career at likely the start of a bear market as we are now (possibly)?

    • Hi Devin

      The tailwind of starting investing shortly after the Great Financial Crises clearly has played a big part of why we achieved financial independence at such a young age.

      We actually did not participate in Vancouver Real Estate appreciation at all as part of our growth in net worth and only bought our home very recently.

      I consider it fortuitous that we had the tailwind, but remember the investment sentiment was not so enthusiastic as today. There was mostly negative sentiment at that time and I purposely kept a low profile on how aggressively we were purchasing stocks to not be dissuaded by friends or colleagues.

      I believe good process is everything and then the final outcome will always have some luck. In 2009, I calculated our savings rate and used modest 6%/year nominal returns and had ourselves achieving FI by early 40’s. That would be after ~15 working years.

      Achieving above the expected market returns over the last 7 years has allowed us some extra lifestyle spending, longer maternity/paternity leaves, and buying a nicer house to live in than we would have done if we hadn’t reached FI yet. We were on the path to FI regardless of what the markets did.

      In regards to if I would alter my process, I can think of one large decision we made that I likely wouldn’t have done to the same degree in today’s climate. I will be touching on that concept within the next few posts, so I wiĺl leave it till then to elaborate.

      Bottom line – at age 30 you still have a HUGE runway of compound growth time left and maximizing that time window is of the greatest importance along with the magnitude of your savings. I can think of a number of people in their 40’s that wished they had heard of FI at age 30!

      The final returns will alter the final FI age range a bit, but if you invoke the process the outcome is all but guaranteed!

      Hope that helps
      FFMD

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