Libya Provides Reminder That Stocks Are Risky

(While I said yesterday that I was going to run a post looking at the performance of Russell's funds, I thought the lessons provided by the situation in Libya were too important to wait. We'll look at Russell on Friday.)

On Tuesday, in the aftermath of the events in Libya, the Dow fell 179 points and brent crude oil rose to more than $107 per barrel. This provides us with just another of the market's regular reminders of just how risky equity investments are. While the markets were able to "shake off" the other recent revolutionary events in the Middle East, they were unable to ignore the Libyan situation, because of its position as a leading supplier of oil.

In fact, there were actually more years when returns were above 20 percent than there were years between 0 percent and 20 percent. There were also the same number of years when returns were between -12 percent and 0 percent as there were between 0 percent and 12 percent.

We've known for a long time that the market's returns aren't normally distributed -- they have what are called "fat tails." Consider the following results from a study by Benoit Mandelbrot covering the period 1916-2003. If returns were normally distributed, we would have experienced:

• 58 days when the market rose or fell by 3.4 percent, yet we experienced 1,001 days
• Six days when the market moved at least 4.5 percent, but we experienced 366 such days
• Once every 300,000 years when the market moved 7 percent in a single day, yet that happened 48 times

There's one other important point I would like to make, one that is discussed in the first chapter of my book, The Only Guide You'll Ever Need for the Right Financial Plan. Investing deals with both risk and uncertainty. As University of Chicago professor Frank Knight wrote: "Risk is present when future events occur with measurable probability. Uncertainty is present when the likelihood of future events is indefinite or incalculable."

We clearly prefer making "bets" when we can at least estimate the odds, if not know them precisely. Unfortunately, as the events of Sept. 11, 2001, or the Enron accounting scandal, the Flash Crash or the tidal wave of revolutions in the Middle East make all too clear, investing is always about uncertainty. However, in good times we tend to think of investing more in terms of risk.

During crises, the perception about equity investing shifts from risk to uncertainty. We often hear commentators use phrases like "there's a lack of clarity or visibility." And when investors see markets as uncertain, the risk premium demanded rises. That causes severe bear markets.

The historical evidence is clear that dramatic falls in prices lead to panicked selling as investors eventually reach their "GMO" point. The stomach screams "Don't just sit there, do something! GET ME OUT!" Investors have demonstrated the unfortunate tendency to sell well after market declines have already occurred and buy well after rallies have long begun. The result is they dramatically underperform the very mutual funds in which they invest. That's why it's so important to understand that investing is always about uncertainty and never choosing an allocation exceeding your risk tolerance. Avoiding that mistake provides you the greatest chance of letting your head, not your stomach, make investment decisions. Stomachs rarely make good decisions.

More on MoneyWatch:
Lessons Learned From the Greek Tragedy Why the Unrest in Egypt Doesn't Matter for Your Portfolio What the Dollar's Reserve Currency Status Means for Your Investments Quest for Alpha: What You Need to Consider When Handling Your Own Investments TIPS Update for February 2011
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• Read my latest book The Quest for Alpha.
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