Oct

2

Risk, from Scott Brooks

October 2, 2006 |

Risk is different depending on your perspective. Lets look at it in a non-academic manner. The risk is as follows:

Lets take a fictional person named Joe in 1975. Joe starts to get his life in order and finances stabilized in his early thirties. He starts saving some money and follows the edict of investing in the stock market.

He experiences extreme volatility for the first few years, but since he's only got a small, nearly inconsequential nest egg, he is able to ignore the extreme swings in the market that occurred from 1975 - 1982. After 7+ years of investing, his nest egg has built to a tidy little amount and by the accident of timing, he now has his decent nest egg positioned to take off with the greatest bull market in history.

And we are off to the races.

1987 hurts him, but he's got such huge gains, that he is able to overcome it, and "hold the course". less than 18 months later, he's back to even and off to the races again. The glitches along the way are still there, but they are quick, fairly painless, and its off to the races again.

By the end of 1999, between his pension account and 401k, he's built up $1,000,000 in his nest egg. Since the market has taught him that he can easily get consistent double digit returns on his money, usually in the upper teens or lower 20's, he decides to roll over his pension and combine it with his 401k in a rollover IRA.

He has expanded his lifestyle through the greatest bull market in history, and thus needs about $100,000/year from his portfolio to live. But that's no problem, with the market "drift" yielding him 15% - 20%/year (heck, in the late '90's, he was getting a 30%+ return), pulling 10%/year off his principle to live each year is no problem.

Then comes 2000.

He finds out he was right about being able to get double digit returns. Unfortunately, he finds out that they also come in the negative variety, too.

He pulls out his $100,000 to live on in year 1, and earns a negative 10% return. Now he's got around $750,000 in his nest egg. But that's only a glitch (and he's experienced these short term set backs before). In a few years he'll easily be over $1,000,000 again.

Then comes 2001.

He pulls out his $100,000 and the market goes down again. Now he has got around $500,000. He begins to sweat. Then comes 9-11. And it scares him badly, but he remembers 1987 and the big run up that occurred afterwards and decides the hold the course (heck, what choice does he have if he wants to maintain his current lifestyle).

Then comes 2002.

He pulls out his $100,000 and the bottom falls out of the market. The S&P 500 is at 755 (off from its 1550 high around the time he retired). Since he was an indexer to begin with, his nest egg is cut in half not counting withdrawals. Counting withdrawals, he is down to under $200,000.

He has to go find a job.

He has to stop taking withdrawals (which he was doing under reg. 72t since he retired early), and in some cases, the "Joe's" of the world mortgaged their houses to take advantage of the boom, and lost all or most of their equity.

Remember, when we talk about drift, and we talk about risk, we are doing so in a largely academic sense. We are discussing it in a manner that the average person cannot relate too.

If you're running a huge hedge fund and have tens of millions of dollars under management invested with you from people that can afford to lose millions and not have it ruin them, or if you are running your own money and can get another "job" if necessary, or have another means of support besides your portfolio, that you have a vastly different perspective on drift and risk than the "average Joe's" of the world who have no other means of support nor do they have the intellectual capital to figure out what to do and how to fix a problem as severe as seeing their entire life's work melt down 80%.

A few years of losses hurt Joe more than a lifetime of gains helped him.

Dr. Kim Zussman responds:

Someone asked earlier "What risk I am compensated for when the drift is a certainty?" I have a few clarifications:

Phil McDonnell adds:

The idea of the long term upward drift in the market is a stochastic reality. It would be inappropriate to apply words such as 'certain', 'always' or 'never' to a stochastic process.

As Dr. Zussman indicated the drift is not guaranteed to be a certain amount or even positive in any one year. It is increasingly likely that your diversified returns will approach the long term drift rate if held long enough. However even the phrase 'long enough' implies risk. For there is no guarantee that one will live 'long enough' to realize the drift rate due to other risk factors.


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