Why do we invest in stocks? Stocks are risky. Why not just buy U.S. treasury bonds and get a guaranteed rate of return backed by the full faith and credit of the U.S. government? We invest in stocks because we are seeking a higher rate of return and are willing to tolerate the volatility of the stock market in order to get that return. This illustrates a fundamental tenet of modern finance, the idea that risk and return are inextricably linked. However, when it comes to investing, not all risk is equal. In an interview on this subject several years ago, the preeminent economist William Sharpe said, “There is a reward and higher expected return for bearing risk, but not just any risk. It’s the risk of doing badly in bad times. It’s that sort of central societal risk that, in an efficient capital market, is going to be rewarded with higher expected returns.”
We should not expect to be rewarded for taking on industry-specific or company-specific risk that can easily be diversified away. For example, I’m a huge fan of Tesla electric cars, but if I put all my investment dollars in Tesla Motors, I would be exposing myself to the risks associated with the automotive industry, electric vehicles, and Tesla Motors itself, risks that may not be rewarded in an efficient market. In order to maximize my expected return for a given level of risk, I need to diversify broadly across U.S. and international equity markets, thereby mitigating company-specific and industry-specific risk, while leaving myself exposed to the central societal risk that cannot be diversified away. Stock markets are priced to reward this societal risk with an expected rate of return above and beyond U.S. treasury bonds, referred to as the equity risk premium. This added rate of return, historically about 5%, is robust and has been observed across many time periods in different markets around the world.
Ironically, in order to capture this equity risk premium, you have to expose yourself to the risk of markets tanking in bad economic times. As we’ve seen with the recent EU referendum in Britain, stock markets are occasionally roiled by economic and geopolitical shocks. While these events can wreak havoc with market returns in the short run, long-term buy-and-hold investors have been rewarded for having the discipline to stay fully invested. To illustrate, here is a partial list of global economic and political shocks since 1970:
Despite this extensive list of real and potential catastrophes, a single dollar invested in the global stock market in 1970 (as defined by the MSCI World Index), would be worth $45 dollars today. Our natural inclination is to avoid stocks during periods of high market volatility; however, a rigorous analysis of historical stock market data has shown that this is not an effective strategy. Attempting to forecast stock market performance based on current volatility is unlikely to be successful. Your best bet is to develop an asset allocation strategy tailored to your investment objectives, time horizon and risk tolerance. Staying true to this strategy in all market environments should be an effective way to pursue your long-term investment goals.
As always, please feel free to contact me with any questions or comments.
Jeffrey J. Brown, MD CFA
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