You Can’t Avoid Risk

Earlier this week, I ran across an interesting tool over on the Vanguard website. It’s embedded in an article called “The Truth About Risk” and it lets you tweak a model portfolio with sliders for stock, bonds, and cash.

The upshot is that you can’t avoid risk. You can attempt to minimize your exposure to it, but there will always be some level of risk associated with your investing activities.

With stocks, you’re facing the possibility of whipsaw performance with wonderfully high highs but dreadfully low lows. With bonds, the highs aren’t as high and the lows aren’t as low, but you’re still facing potentially large fluctuations. And with cash, even though you’ll be protected in a nominal sense, you risk losing out to inflation.

In inflation-adjusted terms…

An all-stock portfolio would have returned an average of 6.71% from 1926-2011 with gains in 56 out of 86 years. The best year would have been +53.41% and the worst year would have been -37.29%.

In contrast, an all-bond portfolio would have posted an average return of 2.49% over the same period with gains in 58 of 86 years. The best year would have been +27.73% and the worst year would have been -16.15%.

And finally, good old cash. An all-cash portfolio would have posted an average return of 0.63% with gains in 54 of 86 years. The best year would have been +12.52% and the worst year would have been -15.05% (gotta love that high inflation in the 70s).

The antidote? A well-diversified portfolio and time. As you can see from the graph below, the range of returns across rolling time periods shrinks dramatically as the period length increases.

In fact, once you get out to a 10 year timeframe, it’s rather unlikely that you’ll face a loss. Possible? Yes. But not likely. And if you do it won’t be very large.