Understanding risk is crucial in investing, as it complements the pursuit of returns. Returns are easily understood. Risks, on the other hand, tend to be trickier. When you ask someone what is the risk of investing to them, most will tell you it is capital loss. They are not wrong. However, risk is not solely about the possibility of capital loss. It goes beyond that. There are many more ways to look at risk and they can be easily mapped to real scenarios and fears close to our hearts. Let me introduce 4 basic metrics you should know that size up the level of risk in portfolios or funds.
1. Volatility - Do You Fear Missing Your Target?
Volatility is one of the industry's de facto measures to size up market risk. Mathematically, it gauges the tendency of your investments to swing up and down from their average return. The larger the volatility, the more significant the swings, and the more uncertain your returns. But many people fail to understand what this means for them.
To put this across simply, just imagine this scenario where you expected an investment you held for 10 years to deliver an annual return of 10% but in the end, it only yielded 3%. You missed your target and big time. Depending on how much that investment matters to you, your reaction can range from disappointment to outright despair. Did you lose any money here? No. But if you need this money, you are going to end up with a serious shortfall. The higher the volatility, the greater the returns can deviate from what you expect.
The 10-yr S&P 500 annual return from 1993 to 2024
Let me illustrate what I meant with a real example by finding out the returns we can get from the S&P 500 if we invest in it over 10 years. We will use the S&P 500 ETF (Ticker: SPY) for our purpose and assume that all dividends are reinvested. To compute the numbers, we will move a 10-year window day by day until we cover the entire period from Feb 1993 to May 2024.
The average annual return over all the 10-year window periods is 8.2%. But that doesn’t mean you will be getting 8.2% because there is considerable volatility. Depending on when you start investing, the annual return can range anywhere from a low of -4.3% to a high of 17.6%. The chart below shows you the contrast between the best and worst 10 years of the S&P 500 in our period of evaluation.
There is no guarantee where you will land. However, if you are expecting around an 8% return, ending up with anything below 4% would certainly be disappointing.
2. Loss and Shortfall - How probable is that?
Knowing that there is a possibility of our investment returns ending up in the red or suffering a big shortfall is not enough. We need to have a sense of what is the probability of that happening. Just like we know buying a lottery ticket has the potential to turn you into a multi-millionaire overnight so why don’t most people keep buying big amounts of lottery at its every run? Because we also know the probability of that happening is next to nothing. It is not that meaningful just to tell us we can lose money or fall short of our target in bad scenarios. That is pretty much a given. Besides that, we also need to have a sense of what the odds might be.
The probability of loss and shortfall over 10 years in the S&P 500
Using the same example earlier where we compute the annual return of the 10-year windows across 1993 to 2024, we can work out the probability of the S&P 500 ending in the red. Assuming we also want to meet at least a minimum target of 4% annual return, we can also work out the probability of falling below that.
Based on the calculations, there is a 9% chance that we will lose money over 10 years with the S&P 500 and a 19% chance your annual return will come in below 4%. So there is approximately a non-trivial 1 in 5 chance that you will suffer a serious shortfall.
3. Maximum Drawdown - How much can you lose in really bad times?
If you are not from the industry you may find the term drawdown unfamiliar. But it is something very simple. It is a measure of how much we lose when our investment declines from a peak. The diagram below will give you a better sense of what a drawdown is. Alternatively, you can watch a short video here.
Throughout our investment journey, we will encounter many peaks and troughs and thus many drawdowns. And the largest drawdown among all these is the maximum drawdown. It is the loss we would have suffered if we invested and liquidated at the worst possible time during the history of this investment.
Why is this important? If the history of this investment is sufficiently long enough to cover multiple market cycles, then Maximum Drawdown can be a fairly useful measure. We can view it as a gauge of how much we can lose if a crisis strikes. With it, you can assess if this is something within our tolerance range. People tend to make irrational decisions when losses exceed their psychological threshold. During such critical times, the last thing we should do is to liquidate our investments at the bottom out of fear only to find ourselves missing out when it recovers. If you want to get out, make sure you have good fundamental reasons behind it.
But having said that, we could also run into times when we need to sell down or liquidate our entire portfolio to raise cash for unexpected needs. And if this comes at the most inopportune time when the portfolio is sitting on its worst loss ever, then we may have to lock in those losses.
But do be mindful, as with all statistics computed with historical data, that the worst that has happened is not necessarily the worst there will be going forward.
The drawdown of the S&P 500 from 1993 to 2024
Between 1993 and 2024, the S&P 500 experienced a maximum drawdown of -55% during the Great Financial Crisis in 2008-2009. So if you hold the S&P 500 over this time, the crisis would more than halve the value of your investments.
4. Longest Drawdown - How long will it take to recover my losses?
This is the longest time an investment took to recover from a drawdown. This is different from the maximum drawdown because the deepest drawdown may not always be the longest drawdown. Similar to a sideway market that gets nowhere, a slow recovery can cast doubts and test the mettle of an investor especially if we see other types of investments gaining ground during this period. That can tempt us into liquidating untimely and moving rashly into other opportunities. So, knowing the possible time it can take for our investment to recover will prepare us mentally.
The longest drawdown of the S&P 500 from 1993 to 2024
The longest drawdown for the S&P 500 between 1993 and 2024 coincides with the burst of the dot com bubble. The entire period of drawdown till recovery lasted more than 6.5 years starting from March 2000 and only ending in October 2006. And barely a year after that, the markets ushered in the Great Financial Crisis.
Conclusion
Understanding risk in investing is crucial for anyone looking to grow their wealth. While returns might seem like the shining stars, risk can ruin all that. We often think of risk as just the chance of losing money, but it's so much more than that. Understanding what you are risking will help you make better decisions and prepare you for the storms that will come your way. And for anyone who is investing for the long haul, I can assure you that the day will come. Risk is part and parcel of the journey. It cannot be eliminated. However, with appropriate diversification and strategies, it can be managed and reduced. So, the next time you're tempted by the promise of high returns, remember to look beyond the glitz and glamour.
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