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102 A Better Way of Measuring Risk Stocks may blow away Tbills and bonds over time, but as we saw, the focus of most investors, fiduciaries, and courts is still on financial risk. The far more potent and universal risk of inflation and taxes is a secondary consideration at best. Academic risk theory also accepts the conventional wisdom by making the Tbill the riskfree investment. The financial academics, like most market participants, also have not incorporated into their equations the largest postwar risk factor, the decrease in purchasing power through inflation. Adjusting for inflation, supposedly risky assets like stocks become far safer. The probability that the investor holding stocks will double her capital every 10 years after inflation, quadraple every 20, combined with 100% odds that she will outperform Tbills or govemment bonds in 20 years, can hardly be called risky.* Conversely, the supposedly * Through the postwar period. Its apparent that this assumption of academic investment theory is far removed from reality. The rational investor should be concemed with the probability of maintaining and enhancing his savings, adjusted for inflation, for retirement, or other future needs. The time horizon of the large majority of investors is not months, quarters, or a year or two. It is many years away, because the need for funds to meet costs such as retirement, college tuitions, or similar goals is usually far off in the future. After all, that is why the govemment set up taxdeferred pension funds, IRAs, and similar programs to build savings, which tens of millions of investors participate in. The investment objective for most people is to maximize savings as safely as possible for the time when they will need to draw on them. The major risk is not the shortterm stock price volatility that many thousands of academic articles have been written about. Rather it is the possibility of not reaching your longterm investment goal through the growth of your funds in real terms. To measure monthly or quarterly volatility and call it riskfor investors who have time horizons 5, 10, 15, or even 30 years awayis a completely inappropriate definition. The volatility measurements provide only an illusion of safety. Its almost like saying that if I walk far out on a beach in Maine when the tide is very low, I am not at future risk. This is probably correct for an hour or two, but it is certainly a shortsighted view of my situation, especially as high tide starts rolling in.
"riskfree" assets actually display a large and increasing element of risk over time. For these reasons, we need a new definition of risk that inco Orates the effects of inflation for investors in the postwar period along with the other types of risk inherent to these investments. What then is a better way of measuring your investment risk? While there can be many definitions even in the business and investment worlds, a good starting point is the preservation and enhancement of your purchasing power in real terms. The goal of investing is to protect and increase your portfolio in inflationadjusted, and (where appropriate) taxadjusted dollars over time. A realistic definition of risk recognizes the potential loss of capital through inflation and taxes, and would include at least the following two factors: 1. The probability that the investment you chose will preserve your capital over the time you intend to invest your funds. 2. The probability the investments you select will outperform alternative investments for this period. These measures of risk tell us the probabilities that we will both maintain our purchasing power and do better than altemative investments for the period we chose.* Unlike the academic volatility measures, these risk measures look to the appropriate time period in the future5, 10, 15, 20, or 30 yearswhen the funds will be required. Market risk may be severe in a period of months or even for a few years, but as we saw, it diminishes rapidly over longer periods. Tables 141, 142, and 143 tell us how stocks stack up against bonds and Tbills after inflation and taxes, and the probability that stocks will outperform them in any period of time. As is apparent, blue chip stocks are by far the best of the three financial investments over time. The careful reader might ask another question here. "O.K., I know the odds of stocks beating bonds and Tbills are increasingly high over time, but stocks have very good periods followed by years of lackluster results. What are my chances of capturing retums above those provided by bonds or Tbills?" The answer is provided in Tables 144 and 145. Table 144 shows the probability of getting stock retums as low as 25% of the average retum for stocks in the postwar period (column 2) to as high as 150 percent of the average retum (column 8) after inflation. The probability of retum is shown for periods of 1 to 30 years. * For the taxable investor, also considering the impact of taxes.
Table 144 Probability of Stocks Meeting Various Levels of Return 1.0 = Starting investment, inflationadjusted 19461996 25% of Marliet Retum 50% of Market Retum 100% of Market Retum 150% of Market Retum   <2)    <5)  <6)   <S)  <9)  (10)   Average   Average   Average   Average   Average Average   Slock   Stock   Stock   Stock   Bond  Tbill  Holding  Port   Port   Port   Port   Port  Port  Portfolio  folio  Prob  folio  Prob  folio  Prob  folio  Prob  folio  folio   Value  ability*  Value  ability*  Value  ability*  Value  ability*  Value  Value  1 year  1.02  (67%)  1.04  (61%)  1.08  (53%)  1.11  (47%)  1.01  1.00  5 years  1.11  (82%)  1.22  (71%)  1.44  (55%)  1.66  (39%)  1.04  1.02  10 years  1.27  (78%)  1.53  (76%)  2.06  (57%)  2.60  (39%)  1.09  1.04  15 years  1.49  (78%)  1.98  (71%)  2.97  (65%)  3.95  (45%)  1.14  1.07  20 years  1.82  (82%)  2.63  (67%)  4.26  (61%)  5.89  (41%)  1.19  1.09  25 years  2.28  (94%)  3.56  (67%)  6.13  (51%)  8.69  (41%)  1.24  1.11  30 years  2.95  (100%)  4.90  (67%)  8.80  (45%)  12.70  (37%)  1.29  1.13 
* The probability that a portfolio will be above the value shown. Column 1 is the total poitfolio value, or wealth relative, in academic jargon, for every period from 1 to 30 years, if you only eamed 25% of the average retum for stocks for each period. Column 2 indicates what your probabilities are of eaming more than 25%. The probabilities, with minor exceptions, of eaming more than 25% increase with time. Thus, holding the portfolio with a starting value of 1, you have a 67% probability or better (column 2) of it reluming at least 2% (1.02, column 1) at the end of one year. The 2% is 25% of the average annual retum of stocks over the past 50 years after inflation. After 10 years it has a 78% probability of increasing more than 27% (1.27, column 1); after 25 years a 94% probability of reluming 128% more than your initial investment (2.28, column 1). So the 25% of the market retum represents "a worst case for stocks," one that should not persist over time. Next, glance over at the portfolio values of bonds and Tbills. You can see that even ifyou take a worst case of receiving only 25% ofthe stock markets average retum, you still do better in stocks than in either bonds or Tbills for any period. By 2 years your portfolio is noticeably ahead, and in 25 years it does about twice as well. Remember again this is almost a doomsday scenario; the chance of making only 25% of the normal market retum is only 6 in 1 when you invest for as long as 25 years. You have a 94% (column 2) chance of doing better. But worst case or no, you still do better in equities than in Tbills or bonds.
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