Stock market risk is the risk of the decrease in the market value of an investment.
In both cases, the portfolio runs out of money sooner than expected, leaving little or no funds to pay living expenses. One measure of riskiness of a stock or portfolio is volatility -- how much the value deviates from its average over time. In statistical terms, it's the "standard deviation".
For example, we can calculate the average and the standard deviation of monthly investment returns
of a security over a number of years. The standard deviation gives a clue to the extent of the fluctuations for the security above and below its average.
The more wildly a portfolio fluctuates, the more likely the odds that it can irreversably deplete your assets.
In the stock market, there is a strong relationship between risk and return. In general, the greater the risk, the greater the return. Based on past volatility and the lack of guarantee of any equity investment, investors expect to be compensated duly for taking a greater level of risk. This compensation is called the risk premium.
Risk is therefore central to stock markets or investing because without risk there can be no gains. You need risk management strategies to minimize the risk and maximize the gain and meet your invetment return objectives.
Stocks and markets
In financial markets there are two major types of risk: the market risk and the specific risk. Market risk cannot be eliminated through diversification, though it can be hedged. Specific risk is tied directly to the performance of a particular security and can be protected against through investment diversification. Sources of market risk include recessions, political turmoil, changes in interest rates and natural disasters.
There are a few strategies that you can use to mitigate the stock market risk.
Diversification irons out risks in a portfolio. Investing in a wide variety of stocks reduces risk compared to a poorly diversified portfolio. Diversification works if the securities in your portfolio are not perfectly correlated. When one asset or sector is faring poorly, the gains on other assets can make up for this loss.
Lack of diversification can give rise to a liquidity risk if significant assets are held in stocks that are traded in low volumes and they cannot be sold in a timely manner.
The percentage of assets held in equities should be in line with your risk tolerance level, time horizon and financial goals.
Even with a low tolerance, there is a need to maintain a share of assets in equities to boost potential investment returns. Common stocks have historically outperformed other investments over time, and are a necessary component of your portfolio.
You will experience low or negative investment returns on your stock returns from time to time. While these losses are painful, recoveries from market declines have been surprisingly quick in recent times. Selling to prevent losses from getting worse means that you may miss a recovery that boosts your account value. Holding good companies that are trading at a lower value are only a paper loss.
In other words, you should follow the trend of the market and recognize that short term trends are "noise" and what really matters are long term trends. However, it is also possible that you will experience a long period of stock market losses. So as you get older, you should be careful to limit your stock market exposure and gradually reduce it to a level that cannot adversely impact your financial security.
A related approach to diversification is holding investments that have a low correlation or are negatively correlated to each other. This is less effective today as markets across the world tend to be highly correlated and stocks and bonds have a low correlation.
If performance is lower than expected, then lowering spending may be the only option if a phased or postponed retirement is not possible.
The stock market risk can also be removed by investing in financial products that hold stocks, but guarantee against the loss of principal, such as segregated funds or index-linked notes. Again, fees and loss of liquidity have to be carefully considered when assessing the benefits of these investments.
What's in store for the future
With low economic growth, high government debt and low interest rates, many have a pessimistic view for the stock markets. What can we expect when formulating expectations for future stock returns?
Vanguard Research published an excellent study entitled "Forecasting stock returns: What signals matter, and what do they say now?" (October 2012).
The Vanguard research looked at U.S. stock returns since 1926 to assess the predictive power of more than a dozen metrics. They found that many commonly cited metrics have had very weak and erratic correlations with actual subsequent returns, even at long investment horizons.
Their research has shown that forecasting stock returns is difficult for the long-term and impossible in the short term. Over a long time horizons, few metrics have predictive ability. While valuations (price/earnings ratios) have been the most useful measure, they have performed modestly, leaving nearly 60% of the variation in long-term returns unexplained.
The study indicates that using the current valuation metrics points to a positive outlook for the stock market over the next ten years. However, it cautions that investing must account for the fact that the future is difficult to predict, meaning that investors should not rely on point forecasts from a forecasting model but instead turn their attention to the distribution of potential future outcomes.
The study concludes:
"A focus on the distribution of possible outcomes highlights the benefits and trade-offs of changing a stock allocation: Stocks have a higher average expected return than many less-risky asset classes, but with a much wider distribution, or level of risk. Diversifying equities with an allocation to fixed income assets can be an attractive option for those investors interested in mitigating the tails in this wide distribution, and thereby treating the future with the humility it deserves."
A study by Russell Investments entitled "Adaptive Investing: A responsive approach to managing retirement assets" suggests that the risk to manage is running out of money, not volatility. It is possible that a higher volatility portfolio could actually reduce the chance of an investor running out of money.
The authors suggest planning for 10 years at a time and plan to have enough money to purchase an annuity at the end of the ten year period. The portfolio must supply cash flows for an uncertain period, we may not live as long as expected, or live much longer. So it is impossible to have a plan that is cast in stone forever. The plan must be flexible enough to account for changes in circumstances such as health, expenses, interests and marital status.
By modeling retirement cash flows, we can see evaluate the risk of a shortfall.
The key metrics to monitor are:
- Funded ratio: the ratio of assets over liabilities; it shows whether assets exceed the value of liabilities today.
- Probability of success: the probability that assets will be greater than liabilities at a future date.
- Magnitude of failure (or expected surplus): the average size of the shortfall (or excess) at the end of ten years in unsuccessful scenarios.
If adequately funded, i.e. a funded ratio around 100%, you can test to see if an increase in exposure to equity risk improves the funded ratio.
If the plan is underfunded, i.e. a funded ratio lower than 100%, the investor has a lower capacity for market risk. It then becomes a gamble to shoot for higher short-term investment returns by taking more risk.
However, if an underfunded plan has a significant probability of success, then increasing market risk could be a good strategy. But if the probability is lower, the optimal approach may be revising the spending plan rather than counting on strong returns.
Lowering planned spending will immediately reduce the liabilities of the plan and improve the funded ratio.