Do U.S. Investors Underestimate Risk?
A common way to reassure clients that a worst-case scenario won’t ruin their financial plan is to show how investments recovered after the Great Depression, the tech bubble, or the global financial crisis. The U.S. stock market may stumble, but portfolios recover over the long run.
But the U.S. is one country – and a country that avoided some serious bad luck that affected other countries during the 20th century. A 2020 paper for the Rodney L. White Center for Financial Research at Wharton showed that investors who base their beliefs about the distribution of possible stock returns on historical data from their home country underestimate the probability of experiencing a significant crash. The authors concluded that the U.S. got lucky, and that this luck may result in underestimating the risk of a significant crash and the extra return we get from accepting investment risk.
Historically, investing in stocks globally has resulted in higher returns on average, especially over longer investment periods. Investors don’t always have a long time horizon, though, and a significant drop in stock prices can wreak havoc on accomplishing many financial goals – for example if a retiree is dealt a bad portfolio return early in retirement. If advisors are underestimating the downside risk by relying too much on the historical resilience of U.S. stocks, they may not be providing investors with an accurate perception of downside risk.
Did the U.S. Get Lucky?
Financial advisors often use historical time periods to provide clients context around how a bad market could impact a financial goal. Using a historical sequence of U.S. investment returns can be far more useful than projecting returns based on historical averages, but we are drawing from a limited sample. We can’t assume scenarios such as the crash during the Great Depression being followed by a historical subsequent boom in the stock market. Actual return sequences outside of the U.S. were much worse.