Rethinking risk in equities

If we’re investing for a long-term goal — and most of us do have horizons of five years or more — then why are we so obsessed with the daily headlines and the gyrations they can spark in asset prices?

Headlines and geopolitical events are nothing new. The market has weathered them and powered on for decades. The chart below illustrates the S&P 500’s resilience through some events of the past 50 years that felt pretty awful in the moment.

Fundamentals over incidentals

Of course, there were ups and downs along the way. Yet volatility often gets a bad rap. It’s generally seen as synonymous with “risk.” In fact, volatility equally creates opportunity. Temporary market pullbacks can create attractive entry points for long-term investors to acquire more shares at attractive prices — that’s if you believe in the long-term case for the company you’ve invested in. And this is key.

Why? Because stock prices change much more frequently than companies’ underlying fundamentals. Stock prices are driven by any number of variables, many evidenced in the chart above: monetary and fiscal policy influences; macro shocks such as debt crises; transient factors like natural disasters; or more persistent dynamics such as demographic or technology changes.

Any of these, or several in combination, can temporarily render stock prices incongruent, or mispriced, relative to the intrinsic value of a company based on its fundamentals. Over time, the evidence shows that stock prices will reflect fundamentals and reward investors accordingly.

Time-in over timing

Even professional investors are not immune from the temptations of short-termism. The industry often defaults to looking at one-month volatility measures — and that can sometimes paint a fairly choppy picture. But if you extend that timeframe and look at three-, five- or 10-year time horizons, volatility smooths significantly.

The chart below illustrates volatility and the probability of negative returns on the S&P 500 over various time periods. Both of these metrics decline across time. By the time you’ve held on for 10 years, volatility sits at 5% and the probability of a negative return is just 3%. That’s a 97% chance of a positive return from U.S. stocks over a 10-year holding period. Compare that to a one-year holding period where volatility comes in at 19% and the potential for a negative return is 28%.

Where the real risk resides

Taking all of this into account, I would argue that short-term volatility is unsettling but is not the biggest risk to long-term investors. Fleeting price changes should be of little concern to someone investing for a retirement that is five, 10, 15 or more years away. They may even represent opportunity, as company fundamentals are the predominant driver of long-term investment returns.

Investors should be more concerned about decisions they make today that can detract from long-term wealth accumulation. Chief culprits:

• Exiting the market on a price drop only to miss a strong rally. History shows it’s better to stay the course rather than try to time the market. Few, if any, investors are consistently good at it.
• Paying too much for an investment. Price matters. Overpaying on a regular basis can create a deep hole to dig out of. We would equally caution against “value traps” — stocks that are cheap, but for good reason. These offer little appreciation potential and could even generate losses. We prefer quality companies with strong business models that we believe can create value over time.
• Losing out to inflation by playing it too safe in lower-yielding but “risk-free” investments. Stocks are yielding more than bonds today, and their dividend income can grow over time whereas bond coupons, by definition, are “fixed income.”

Tony busts 3 myths about quality stocks.

In an information-intensive, fast-moving world where instant gratification is prized, I would make the case for the rewards of practicing patience in your investment strategy. Economist Paul Samuelson once said, “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”

I’d say your financial future isn’t worth the gamble.

Tony DeSpirito is Chief Investment Officer for U.S. Fundamental Active Equity and a regular contributor to The Blog.

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