Passive investing part 8: get paid for that risk

This is part 8 of my posts on passive investing for Europe based investors. I hope that the previous posts gave you some high level understanding of options for a passive investment portfolio. In this post I’ll explain my view on how to allocate your portfolio and why I think much of the advice you get at the moment is either outdated or irrelevant for many people.

Volatility of returns is a poor measure of risk for many investors

As discussed in part 7, equities clearly provide much less stable returns but over a very long period of time they beat any bond portfolio by a huge margin. Even in spite of this fact, many individual investors are advised to diversify and split their portfolio roughly 30-40% in bonds and the rest in equities.

In general the idea is to make the portfolio returns more “smooth”. However, the same way as it doesn’t make sense to buy every insurance policy available to you, you shouldn’t hurt your long term results by avoiding a risk that might not even be a risk for you.

The supposed riskiness of equities comes from the fact that prices fluctuate (sometimes a lot!) and there’s no clear floor below which they can’t fall. Having said that, if your investment horizon is long, say 20 years, and you don’t use borrowed money to invest, this is hardly a risk for you! If you imagine yourself in 20 years from now, getting 7% annualized return over the period with two bad years when your portfolio dropped 25%, does it matter for you?

Get paid for the risk you’re not taking

If you chose to stick to (“less risky”) government bonds instead, assuming a return of 2% you would end up having 1485 euros for 1000 euros invested. If we assume that equities returns is usually approximately 5% above bonds, i.e. 7% annualized return over the period, you would have 3869 euros in 20 years!

As a result, choosing to be shielded from the short term price fluctuations cost you almost 2400 euros on 1000 euro investment!

Now of course this argument gets more difficult if you’re getting close to retirement age when you need to start closing down your investments to finance your regular life activities. But especially at younger age, the returns given up by choosing an overly defensive investment profile can be extremely dramatic!

In the next post I will write a bid more why the advice to invest in bonds might be outdated.

Please share any questions or thoughts on the topic in the comments section below!

Published by everydayinvesting

Amsterdam based. There will definitely be a bias towards topics relevant to my work. I'm interested in investing, markets, economics, politics, history but also machine learning, statistics and how (whether) all these can be combined. I have questions and let me know if you have answers! Always happy to discuss any of the below and more. - can machine learning be applied to investing? - what's the future of active investment management? - what's the future of passive investment management? - where's the best trade now?

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