If you don’t have a proper understanding of what risk means as a long-term investor you will struggle to have the composure required for long-term success.

What Risk is Not

Contrary to common belief, equity market exposure is not the primary risk for investors. Without exposure to risky assets, it is impossible to meet future return objectives, such as beating the inflation rate (CPI+%). Therefore, having exposure to the market serves an essential strategic purpose. Unfortunately, many long-term investors mistakenly perceive market volatility as their primary risk. While market cycles are a normal part of investing, experiencing inevitable downturns can significantly change our perspectives and influence our behaviors.

Understanding Risk

For the long-term investor risk is not having enough when you need it.

Over the long-term the market is going to work its way higher with or without you. Intuitively we all know this. The investors aim should not be to beat the market but rather to harvest the returns that the market provides. The illusion of relative outperformance leads to sub-optimal human behaviour that results in poor decisions. Poor decisions lead to undesirable outcomes.

Beating an external index is not a personal goal. Funding a future need is. By carefully considering the desired outcome and intentionally constructing a portfolio that has a high probability of achieving that goal over time, the investor’s behaviour becomes the determining factor. The portfolio should be structured to capture the positive effects of the market over the investor’s time horizon, without relying on predicting the future. It should be purpose-built to deliver the desired outcome through all market cycles, acknowledging that market fluctuations are temporary and that gains over time tend to reset to higher levels.

The purpose of a well-managed portfolio is to consistently tilt the odds in favour of the investor, increasing the likelihood of reaching the desired outcome within a specified timeframe.

Uncertainty is a Reality, Not a Risk

It is essential to recognize that the market does not become more uncertain when it goes down. Uncertainty has always been an inherent characteristic of the future. Long-term investing involves accepting and embracing this permanent feature of the investment landscape.

Our brains often trick us into perceiving uncertainty as danger, triggering a “fight-or-flight” response that is only suitable for life-threatening situations. History teaches us that inaction is the best approach to navigate market volatility successfully.

Long-term investors will inevitably experience periods of discomfort. Every decision that we make involves trade-offs. By maintaining a proper perspective, we can make wise trade-offs, especially when they involve the interests of our “current self” versus our “future self.”

What Matters Most?

Every investor is bound to experience discomfort when investing in risky assets. However, an important choice must be made: when would you prefer to endure this discomfort? There are two options:

1. Deal with the short-term discomfort of market downturns while remaining committed to your investment plan.
2. Choose to alleviate short-term discomfort, which will result in long-term discomfort of not having enough when you need it.

Opting for short-term comfort often leads to enduring long-term discomfort. Unfortunately, history has proven that this choice is binary and has deep and lasting impacts. The best policy has always been to adhere to a well-thought-out long-term plan.

The True Risk

The long-term variation in performance among investors is primarily explained by their behavior rather than the impact of market conditions. Successful investors do not possess extraordinary insights for timing the market; they simply manage their natural instincts better. When fear triggers our instincts, our perspective shifts. Overcoming this fear response is what sets apart good investors from the rest. Although the concept is simple, it is not easy to execute.

The market itself is not the primary risk in achieving long-term goals. As investors, we cannot control the markets. However, our behavior is within our control, and it represents the most significant risk we face.

“It is not what is happening to you, but how you respond to it that matters.” – Epictetus

It is perfectly normal to feel fear during market downturns, especially when bombarded with negative media reports. However, it is crucial to recognize that media prognosticators have a poor investment track record when their predictions are scrutinized. It is important to remember that they do not genuinely care about your long-term goals. Sensational and negative news sells best, as their business model relies on generating attention and advertising income. Their motives are not aligned with yours.

“When you zoom in, you obsess. When you zoom out, you observe” – Rick Ruben

The Stoics believed that you eventually become what you give attention to. Protect your attention from negative external news flows and inputs that will not enrich your life.

“What you pay attention to influences your thoughts, which impacts your actions, which determines the outcome of your life”.  – Darius Foroux

When we focus excessively on daily news flow, it influences our behaviour and manifests in our actions. History has demonstrated that this approach leads to poor outcomes and regret. By zooming out and focusing on our long-term goals, we regain a proper perspective. Commitment to the discipline of long-term investing serves our higher purpose.

Therefore, it is crucial to be mindful of what we choose to give our attention to.

 

The above article was written and adapted by Marius Kilian.

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