A recent Morningstar online article says that a “great insight” by Jack Bogle, the founder of Vanguard, is the difference between absolute and relative predictability and hence of risk. Viewed this way, the article says “cash can be highly risky and stocks can be fully safe.” To me that notion is pure gibberish. How can they say this?

The article points out that one day in 2008 the Reserve Primary Fund, a money market fund, dropped from the almost universal $1.00 to $0.97 per share because it held too much of Lehman Brothers paper when the firm was seized by the government and declared bankrupt. (After the legal wrangling and government actions, holders of the fund eventually received over 99 cents a share, so the loss was less than one percent.) This “breaking the buck” was a shock. According to the article this shows the relative risk of holding the fund and presumably any cash equivalent is large although the absolute risk measured by the severity of the loss is quite small.

On the other hand, a low cost stock index fund will perform as expected, so its returns will not be a surprise. The Vanguard Index 500 fund, which tracks the S&P 500 Index with dividends reinvested, is the pioneer index fund. During the severe cyclical bear market that began in the fall of 2007 and bottomed out in March 2009, both the index with dividends and the index fund fell slightly more than 55%(*). But this was no surprise since the index fund did exactly what would be expected. So there was little relative risk to holding the fund. I doubt that would have been any comfort to anyone owning the fund during that period.

Is there some value to considering relative risk rather than absolute risk, the chance of suffering a severe downturn in one’s holdings? There is to Bogle, Morningstar, and those who believe that buying, holding, and hoping is the best way to manage one’s investments. As you know, that is not what I think. Saying that holding money market funds, which once in 40 years suffered a very small loss, is somehow riskier from a relative viewpoint than holding stock index funds, many of which lost more than half their value twice in this century, is pure gibberish to me—technically correct by one definition, but dangerous to one’s wealth.

When I evaluate trading methods, I focus on various measures of absolute risk, the probabilities, durations, and extents of drawdowns. However, that is not the real meaning of investing risk. As an extreme example, Bill Gates, Warren Buffett, and other billionaires could lose considerably more than half of their wealth without any effect on the way they live. The real meaning of financial risk is not having enough when it is really needed. The meanings of “enough” and “really needed” are highly personal, so there is no general way to include that type of risk analysis of particular investments. At best, a proposed portfolio can analyzed to estimate the probability the financial objectives at a certain point in time will be achieved.

(*)The index fund fell by 0.04% less (55.04% vs. 55.08%) than the index effectively “benefiting” from the expenses removing assets from plunging stocks!

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