A Sheep in Wolf’s Clothing

It’s easy to overlook the fact that, in thinking about investment risk, we are implicitly making a choice about the benchmark against which risk is measured. It’s a convention, which we often take for granted, to use our local hard currency as the risk-less benchmark – but this choice, while very convenient, can also be misleading.

Let’s take the case where what you really care about is what you can buy with your wealth over your lifetime. You’re 50 years old and you can purchase an investment in your brokerage account, with a solid government guarantee that pays one dollar each year for the next 50 years and is adjusted for inflation in the exact goods and services you want to buy. That’s a “real annuity”; right now, you can buy it for $40, but the price is always fluctuating as supply and demand drives changes in real interest rates. In fact, one year ago, the price was way up at $65 – and so, had you bought it then, your brokerage statement would now be showing a loss of about 40%.2 Is this a risky investment?

The present value price of the real annuity fluctuates (wildly, in this example) while its long-term spending power remains constant. If you have a short horizon, it’s definitely risky – but, in terms of your personal spending that can be supported by buying the annuity and holding it, there’s no risk. Similarly, the spot prices of US inflation-protected bonds (TIPS) fluctuate a lot, but since they can be assembled into a portfolio similar to a long-term real annuity, they’re not very risky at all if you’re primarily concerned with supporting your long-term real spending.

What about the stock market? We know that stock markets fluctuate pretty significantly year-to-year, often varying from base-case returns by 20% or more. When we measure the long-term realized volatility of the stock market, we get estimates for the annualized standard deviation of returns in the 16% to 20% range for most broad markets in major currencies – but what if we thought about investing in the stock market from the perspective of our long-term real spending power, where real annuities and TIPS are essentially risk-free? How much would that change our assessment of stock market risk?