When it comes to investing in the stock market, the risk that everybody talks about is the ups and particularly the downs, the bearish periods when the market falls dramatically and keeps falling for months or even years. (Think 2000–2002 or 2008–2009.)
The real damage isn’t the fall itself, but the fact that many investors watch the ongoing free-fall with increasing horror until they can’t stand the pain any more, sell out of the market at or near the bottom, then lick their wounds on the sidelines and miss the recovery. Over the course of this round trip, they lose real money, while those who had the fortitude to hang on, recovered their losses.
An insidious risk to wealth
Recently, professional advisers have begun talking about a different dimension of risk, which is just as insidious, and potentially damaging to the wealth of their clients, but much-less-widely discussed. It’s called “frame-of-reference” risk.
Frame-of-reference risk is as follows: people will look at the performance statement of their diversified investment portfolio and notice that its return is falling short — sometimes, far short — of the market index they’re most familiar with, typically the Dow or the S&P 500. They abandon the diversified investment approach and concentrate their holdings in the local market, right as the other investments they sold are about to take the performance lead.
So what exactly are the advantages of hanging on to a diversified portfolio?
The mathematics of returns
One answer lies in the mathematics of returns. A loss of 10 percent requires a modest 11 percent gain to get back to the original portfolio value. But a 20 percent loss requires a 25 percent gain, a 30 percent loss doesn’t recover until the portfolio has achieved a subsequent 43 percent gain and a 50 percent loss doesn’t get back to even until the battered portfolio gone up 100 percent. When a portfolio holds different asset classes, which move up or down out of sequence with each other (which, in the vernacular, are “not highly correlated”), it tends to smooth out yearly investment performance. Portfolios that deliver smoother returns don’t have to experience extreme recovery to stay in positive territory. As a result, they will have higher terminal values than choppier portfolios, even if the average yearly return is the same.
This can be summed up neatly by looking back at the investors’ dilemma during the tech bubble. People who held a diversified mix of the four asset classes — U.S. stocks, foreign stocks, commodity-linked investments and real estate — enjoyed a 13.05 percent average yearly return from 1994 through 1999. They achieved a 9.96 percent return in the subsequent five years, from 2000 through 2005.
Were they happier with their higher return in the first five years? No. They were challenging their advisers, because the U.S. stock market happened to be gaining 23.55 percent a year and they felt like losers. Were they unhappy with the lower 9.96 percent yearly returns the diversified portfolio delivered in the subsequent five years? No. In fact, they were ecstatic, because their portfolios were outperforming at a time when the U.S. market was losing value.
Of course, many investors today are facing this frame-of-reference risk head on.
Today, when the U.S. markets are enjoying a long uninterrupted run of good fortune, frame-of-reference risk starts to come out of the closet and threaten your financial health. All we know about frame-of-reference risk is that, just like the more well-known volatility risks, it lures investors to abandon their long-term strategy at the wrong time — and when people give in to it, it becomes a net destroyer of wealth.