September 1, 2011, was a beautiful day. Photographer Gary Elliot was taking pictures at Swami's, a popular surfing beach in Encinitas, California. The surf was high that day, but nothing else seemed out of the ordinary.
When reviewing his photographs later, Elliot noticed a large shark fin in a cresting wave near several surfers. There had been no reports of sharks. As confirmed later by experts, the size and shape of the fin indicated a great white shark, about 12 feet long and weighing roughly 1,000 pounds.
This remarkable happenstance is a powerful metaphor for investing in stocks. Equity investing offers uncertain rewards but certain risks, no matter how beautiful the weather or how calm the seas. These risks are often opaque to us. There is no way to know if and when those risks will bite and what the extent of the damage will be.
Yet investing in stocks is crucial for investors to reach their financial goals because of the returns they provide. Risk and reward are inherently connected. Suppose, for example, back in 1928 you had invested in stocks (the S&P 500), bonds (10-year U.S. Treasury notes) and cash (three-month U.S. Treasury bills) and held on through the end of 2016.
Over that period, stocks averaged 11.42% annual return, bonds 5.18% and cash 3.46%. In other words, if you had invested $100 in each of those categories, at the end of 2016 you would have had $1,988 in the cash account, $7,110.65 in the bond account and an astonishing $326,645.87 in the stock account — over that period, stocks earned 165 times more than cash and 46 times more than bonds.
Risks & Returns
Unfortunately, however, that enormous benefit comes with drawdown risk. Stocks suffered enormous losses of more than 20% six times between 1928 and 2016, and in 23 of 89 years — roughly one in four — provided negative returns.
That unfortunate reality causes investors of all sorts to make bad decisions (performance chasing, buying when markets are high, selling when markets are low, etc.) such that investor returns over time are dramatically lower that investment returns.
Many people claim to be long-term investors. Very few really are.
Some investors react to drawdown risk by hoping to buy stocks that only go up. Those stocks do not exist. For example, most people would cite Amazon as exactly the type of stock they want to own. A $10,000 investment into Amazon shares purchased at its initial public offering in 1997 is worth roughly $5 million today, far better than market returns.
However, Amazon shares have seen daily declines of 6% or more 199 (!) times, have fallen 15% over a three-day span on 107 different occasions and have suffered at least 20% pullbacks in 16 of its 20 years of public trading. The drawdown risks have been immense.
Other investors react to drawdown risks by insisting that the right approach or the right manager can avoid them somehow. That is a fool's errand, too.
