News

Retirement Weekly: If COVID-19 taught us anything, it’s to expect the unexpected

The second anniversary of the COVID-19 pandemic is a perfect time to reflect on risk and how it might impact your retirement financial security.

It was two years ago this week—March 11, 2020, to be exact—when the World Health Organization formally declared COVID-19 a global pandemic. Yet, just two or three months before that declaration, no one outside a handful of epidemiologists had even heard of the virus, much less were worried that the economy was about to be put into the equivalent of a medically-induced coma.

Read: Two years of COVID-19: How the pandemic changed the way we shop, work, invest and get medical care

But even if you did somehow have advance knowledge of the pandemic and that we would be struggling with it in two years’ time, you still would have gotten it wrong. You undoubtedly would have predicted a prolonged period of poor stock market performance (or worse). I highly doubt that any of you would have guessed that the stock market today would instead be some 50% higher.

Nor can we overlook how Russia’s invasion of Ukraine took everyone by surprise. Even though Russia several months ago started amassing troops on the Ukrainian border, few expected the country to actually invade. It’s not even clear that Russian President Vladimir Putin himself knew what he was going to do. Furthermore, the strength of the Ukrainian resistance “continues to surprise Russia,” according to a British intelligence report.

As if that’s not enough uncertainty, it’s rumored that Russia is contemplating the use of chemical, biological or even nuclear weapons in Ukraine. It’s hard to overstate the associated risks.

Is the sea really calm after the storm has passed?

I could go on and on.

But none of us—least of all retirees—need to be reminded that the future is uncertain. Instead, we need to be reminded of how this uncertainty and risk play out over the long term.

The traditional belief, repeated by almost every adviser and financial planner, is that the markets eventually recover and things ultimately calm down. Wharton professor Jeremy Siegel, in his book Stocks for the Long Run, is famous for showing that the standard deviation of returns declines as holding period lengthens.

This is illustrated in the accompanying chart, which I produced after updating data presented in Siegel’s book. When holding stocks for one year, for example, the standard deviation is more than 18%. Per statistics 101, that means—on various assumptions, including that the future is like the past—95% of years should fall within two standard deviations above or below the average. That’s a very wide range of over more than 72 percentage points.

Notice that, at the 10-year horizon, however, the standard deviation drops below 5%. And when holding period lengthens to 30 years, it drops below 2%. That implies that 95% of all 30-year returns will fall within a range of 8 annualized percentage points—a lot less than 72 percentage points.

I’m not sure how useful this information is, however. As British economist John Maynard Keynes argued a century ago, “Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.”

Consider research conducted by Robert Stambaugh, a colleague of Siegel’s at the Wharton School, and Lubos Pastor of the University of Chicago. Their peer-reviewed study, which was published in the Journal of Finance, is titled “Are Stocks Really Less Volatile in the Long Run?” The professors in effect argue that the U.S. stock market over the last 220 years got lucky, and there is no assurance that in the future risk will decline as holding period lengthens.

The complex statistics the professors employ is beyond the scope of this column, but I described their findings in greater detail in an October 2020 column. But one of their conclusions that is particularly sobering is that, when holding stocks for 30 years, your risk is nearly 50% greater than when holding for just one year.

Another study, by pursuing a different statistical approach, reached largely similar findings. Titled “The Volatility of Stock Investor Returns,” the study was conducted by Ilia Dichev, a professor of accounting at Emory University, and Xin Zheng, a professor of accounting at the University of British Columbia.

The professors focused on investors who are actively trying to beat the market, and measured how much more volatile their portfolios will be than a simple index fund. The professors found that at “the 10-year horizons the [investors’ portfolios]… are about 15-20% more volatile [than the overall market] but this differential rises to 70-75% for the 30-year horizon specifications.”

A third approach is to calculate how much an insurance company would charge you for a hypothetical policy that insures against your portfolio losing money. This approach to analyzing risk was proposed decades ago by Zvi Bodie, who for many years was a finance professor at Boston University. Upon applying the standard theoretical formulae for such a calculation, Bodie found that, as time horizon lengthens, the cost of such insurance rises.

The investment implication of these studies is that risk is far greater than we previously thought. A corollary is that sources of guaranteed income—annuities, for example—become more important than ever. Only after we’ve made sure that our basic needs will be met should we even contemplate making speculative bets in our portfolios.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.

What's your reaction?

Excited
0
Happy
0
In Love
0
Not Sure
0
Silly
0

You may also like

More in:News

Leave a reply

Your email address will not be published.