Risk and Reward

Previously, we compared the choice between bank savings accounts paying roughly 5% interest on savings to investing in the Standard and Poors 500 index which averages approximately 10% over time.  In order to double your return rate, investing involves an element of risk.  The risk of investing versus collecting bank interest is that an investment can, in extremely rare cases lose 100% of it’s value.  By assuming this risk, a prudent investor can generally earn double the return of a bank savings account (10% versus 5%.)

If you do not wish to think much about investing, or are extremely fearful of losing your savings, then buying shares of an index fund, such as one that corresponds to the S&P 500 offers a simple solution.  Whenever the overall stock market increases in value, you will earn a corresponding return.  Bank savings accounts offer the least amount of risk, and the lowest return.  Index funds will usually double that return, but with the introduction of a moderate risk.  That risk, in the absolute worst case, is the possibility of losing your entire savings.

As a practical matter, it is highly unlikely that an index fund based on the S&P 500 would ever go to zero value.  The S&P 500 is a collection of shares of the 500 top companies, mostly based in the U.S. but also other countries in the global economy.  To reach a zero value, all 500 of those companies would have to simultaneously fail entirely.  Even during the worst depths of the great depression,  when the market lost 90% of it’s value at the absolute lowest point, it still did not go to zero.  Most investors who could afford to retain their shares of stock, saw them recover to a loss of something closer to 50%.  Eventually, even those losses were recovered, though it took several years and a World War before the markets began growing steadily again.

When I examine my own risk as an investor, I assume that the absolute worst case scenario is likely a 50% loss.  As I am not into investing for the purpose of losing money, I hope that will never happen.  Nevertheless, I plan for the future with the understanding that a loss of 50% of my portfolio could occur at any time, instantly and without a warning.

A sudden 50% loss of value is even less likely for those who invest only in the S&P 500.  It is simply unlikely the those 500 companies could all lose 50% of their value, all at the same time.  This is the value of diversification.  An investment in the S&P 500 index lowers the risk of investing losses because it is far less likely that all 500 companies would suffer a devastating loss than it would be for any one company to suffer a devastating loss by itself.

Individual companies may risk sudden failure but they also have the potential for higher return than an index fund.  An individual stock may double, triple or increase in value by a factor of ten in just a few years time.  An index fund is limited in producing those kinds of returns for the inverse reason that it is likely to never go to zero.  It is unlikely that 500 companies will ever simultaneously double or triple or increase tenfold within a 2 year period.  So it happens that diversification lowers your risk, but also lowers your potential reward.

Conventional wisdom is that investors must diversify to lessen their risk.  What the conventionally wise don’t tell you is that diversification will also probably lessen your reward.  Warren Buffett has famously said that “Diversification is a protection against ignorance.”  But he adds “It makes little sense if you know what you are doing.”

I agree with Buffett on both counts.  If you don’t wish to spend any time thinking about investing, then diversification is the right choice for you.  If, on the other hand, you enjoy researching what makes a company successful, you can achieve far more than a 10% annual return.


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