Investment risk is commonly misunderstood solely as "loss of value." More properly understood, investment risk is defined by a balance between two important factors: a declining asset value, and the loss of future purchasing power due to inflation. Less of one of these two risks usually leaves you with more of the other.
Because normal markets are volatile, volatility is expected but cannot be predicted or controlled. Every investment comes with volatility, but the further you zoom out the harder it is to equate volatility and risk. Both normal volatility and investment risk can be mitigated by combining a strong financial plan with a diversified portfolio. You can prepare for a market downturn with an appropriate emergency fund.
This article is a transcription of a conversation between Jonathan DeYoe and Scott Jacobs on misconceptions about risk and best practices for managing investment risk.
What Is Risk? 0:0:30
A Behavioral Approach to Risk Management 0:1:50
How Much Risk Can You Tolerate? 0:3:30
Real Risk vs. Fear of Risk 0:7:20
Perceived Risk vs. Real Risk 0:11:40
Managing Risk with Emergency Funds 0:13:40
Two Common Misconceptions About Risk 0:19:05
The Downside to Risk-Free Financial Success 0:23:10
Financial Storytelling Vs. Data: Two Ways to Understand Your Money 0:26:30
Prediction vs. Planning 0:27:55
Return to Learn About Portfolio Building 0:31:00
Jonathan DeYoe: I want to very quickly introduce an idea we want to share with everyone. We get a lot of questions from clients and from the community. What we are going to do is we are going to start having short conversations about specific questions. Today's common client question is: what is risk and how do you figure out what's the right amount of risk for you? So, Scott, with that, what is risk? What do you think it is? How do you see it when it's represented with a client?
What is Risk?
Scott Jacobs: I first want to look it up on Google and I think it's worth mentioning to whoever's reading what risk is. Google characterizes risk as three different definitions. Risk is measured by the probability of a threat, the vulnerability of an asset to that threat, and the impact it might have if it occurred. Risk can also be defined as the uncertainty of outcome, and it can be used in the context of measuring the probability of positive outcomes as well as negative outcomes.
I think it's an interesting word. We were talking about this earlier, but I feel like risk really means different things to different people. And so from the standpoint of what risk means to clients, to the people we work with, it feels like there are two sides of the equation. One, the risk of a depreciating asset base. My assets can go lower and what’s the risk? But then another risk that we think is very real and is becoming more and more prominent is the risk of my future purchasing power, due to inflation. And so I think those are two different sides of the word risk. But I think you, Jonathan, probably want to speak to that as well.
A Behavioral Approach to Risk Management
Jonathan DeYoe: I think when we think about the behavioral approach there is a real risk that we try to manage for, and I think there are two risks that people bring to the table a lot. I think the first one is FOMO, fear of missing out. We see that a lot. And that is me, or an investor, responding to something going on in the world where everyone's making a lot of money and thinking, “Jeez, wouldn't it be nice if I could make a lot of money too?” And then you already spoke to the second one, this behavior. And that's the fear of losing capital, which is at the forefront of everyone's mind until it's not, which is usually when it should be.
The risk that we have to manage comes in when you're making a financial plan and you're writing out the targets. Once we have realistic targets set, then the risk becomes missing those targets. And so, if you can create guardrails around a portfolio, such as cash on the sidelines, you can manage risk. Whatever the structures are that enable people to hit those targets regardless of volatility, I think that's where success comes in.
Most people incorrectly define risk as volatility (market zigs and zags). We think “Oh, my goodness, it's all over the map, so I'm scared of it. Therefore, it's risky.” Whereas it's just the normal state of markets and economies that volatility exists. It is almost always our emotionally driven decisions that create the problem.
Scott Jacobs: To your point, when people think about markets going up and down, losing capital, they think that's risky. Sometimes if you just bring to the surface that over 70% of the time markets are positive, risk is actually mitigated by some of the long-term data. I don't think people even realize that sometimes.
How Much Risk Can You Tolerate?
Jonathan DeYoe: So how do you know? What's the right amount of risk for somebody?
Scott Jacobs: I think we ask this question in an interesting way to our clients. When we have an introductory conversation with a family, we ask questions like “you're on a game show and you win ten thousand dollars. Do you risk all of it for a 25% chance of winning twenty thousand dollars? Or risk a certain amount more to win fifty thousand?” And that really helps us understand how willing they are to put all that capital at risk to gain so much more. I love that question.
We have another question that I really like, which is using a round number like, let's say a million dollars. We ask, “If the portfolio dropped to nine hundred thousand, a 10 percent decline, do you have a stomach ache yet? How about a 20 percent decline? How about a 30? When are you and your spouse or you and somebody really having an uncomfortable dinner and losing sleep?”
I think that volatility and being comfortable with the risk of that volatility, sort of help predict what you should or should not be doing based on your emotional reaction, or visceral reaction, to these kinds of movements in the market. I love those two questions we ask. It really separates where people stand.
Jonathan DeYoe: Once you know how somebody feels about risk, then how much is the right amount of risk for them to take? You don't want to have the emotional response drive the portfolio. You want to have the plan drive the portfolio, but you can't push the portfolio so far that the risk scares the client away. It's like a balancing act between the stuff that they want to have accomplished and the volatility they can stomach in the portfolio. There's got to be a midpoint there. Once you know that midpoint, what is that? You can't take more risks. What's this? What do you solve for?
Scott Jacobs: It's a really interesting question, I think that's the, you know, twenty-four thousand dollar question for families. You need to try and peel the onion back appropriately to get the answer.
One thing worth mentioning around this is that all too often somebody wants to have an 80-90% equity (way more equity/stock exposure and volatility than would be necessary) to get from today to their future. And we realize why would you do that if a 60/40 (60% equity), or a 70/30 (70% equity) gets you the outcome you want? There's that element of a conversation. Their head is thinking a certain way. Their heart is thinking a different way and the behavior it’s creating is even more complicated.
So, that's a great question. It's a really decent question. What's the right amount of risk, knowing how the path leads you to the end, to a positive outcome? And yet they're not comfortable allocating capital the way the plans require to get to where they have to go. So that's a tough question.
Jonathan DeYoe: If they can't take that much risk, what do they have to do to find other options?
Scott Jacobs: They have to stop going out to dinner. That's one of the levers, stop spending so much money.
Jonathan DeYoe: I think we can always save more and put more in the plan. You can take less risk, but it's really a tradeoff. You have to do one or the other if you want to get to specific outcomes.
So how often do you think that we should reevaluate? How often should we look and determine what your risk profile is today?
Real Risk Vs. Fear of Risk
Scott Jacobs: We haven't had a conversation in a while that relates to really drilling down on risk, but I think if you're not having that conversation at least once a year, you are misfiring. I think that the risk conversation has got to come up at least on an annual basis and maybe semiannually, depending on the stability of the family, the individual, the client.
Some people understand markets go up and down 15 percent a year and then they come back, or they don't, and they are okay with that. And some clients are going to reach out several times a month throughout the year because they're not okay with that. It really depends on the individual.
Jonathan DeYoe: We see clients face to face to talk about their plan once a year or twice a year, sometimes three or four times a year, depending on the client. I think what you're really saying is you should be reviewing risk every time you sit down with somebody.
Scott Jacobs: That's fair.
Jonathan DeYoe: If we see you twice a year, we're going to ask the question, how are you feeling with the way things are going, every single time. And I'd say it's an ongoing conversation. Markets were up so you were up last. Are you okay with that? Markets are down so you are down. Are you okay with that?
Scott Jacobs: The other thing to mention around this, too, is that we've been in this world a long time now. And I think about how in a raging bull market before the tech bubble, people would look at you, you know, in the whites of your eyes and say, “I have a huge risk tolerance. I'm good.” And in a raging bull market, that's really easy to say. But when the Nasdaq went from five thousand to eleven hundred in a sneeze, all of a sudden people realized, well, maybe I don't have the risk tolerance I once thought I did. I don’t want to say malleable, but risk is fluid.
I don't know if people realize what the risk is until they're really tested and have experienced what it's like to be going through a really uncomfortable time in the markets. That's creates the discomfort, when you're getting hit and your portfolio is dropping for three straight years like it did in the tech bubble. Not one year, not two years, but three straight years. If you were in too much growth, too much technology, which a lot of people in this part of the country were, I think that tested a lot of people, not just their patience, but their risk tolerance. It's really a function of the environment you're in which also creates an opportunity to figure out what your risk tolerance may or may not be. It's not always the same. It will change.
Jonathan DeYoe: You might remember this from a couple of years ago. We had a client sitting at one of our events, and he came up to me afterward and he finally said, “Jonathan, I finally got it. You don't manage portfolios, you manage people.” Let’s take someone who woke up on the right side of the bed this morning, had a fantastic workout, and a great breakfast. They might say “My wife gave me a big kiss and made me feel just wonderful. And then someone gave me a risk tolerance questionnaire and I filled it out. Dude, I was like, give me all the risk you can give me. Right. I love this. It is great. I could handle the world. No problem.” How do you adjust for that? A one-time questionnaire doesn't do anything. It's not just a one-time thing. It's something you have to revisit on a regular basis.
Scott Jacobs: Maybe it's a little bit oversimplified, but it's almost like blood work. You've got to keep looking at it because it's not static.
On the other side of the equation you just made, what about a guy who's going through a nasty divorce? We talk to people like that all the time. What about a guy whose youngest child just got his first DUI or his business is failing or he's got an aging parent that's got dementia and then we give him the same profile. We won’t get the same outcome. You make a great point. It's definitely not a static thing. It kind of moves around depending on where you're at. And it may not have anything to do with the markets.
Jonathan DeYoe: Totally, If I miss my meditation for two weeks, I'm risk-averse. If I have my meditation in line, I'm good.
Let's pretend for a second we have somebody, they are a great client, and we understand the risk profile. What are the tools we can use to actually help them manage risk, both perceived risk and actual risk?
Perceived Risk Vs. Real Risk
Scott Jacobs: March 2020 was a great example of this. And the truth of the matter is it's hard to prepare people for a 28 day decline steeper than we’ve seen in one hundred years. There's only so much preparation you can do. And that's where education comes in, the webinars and the podcast and things of that nature.
I think our level of communication is really important. Ongoing communication is really important. But there's a certain amount of risk that you almost can't prepare for, the unexpected—like the pandemic. We let people know we've had unexpected traumas and crises before, but we just don't know what the next one is going to be, or how violent it's going to be. What we do know is that it is going to be temporary because they always have been. But I'm sure you have something to add to that.
Managing Risk With Emergency Funds
Jonathan DeYoe: I think what you were going to there was the constant communication. One of the ways that we've prepared people from 2008 to 2020 or to, let's say 2010 after 2008, was constant communication about the possibility, or the probability, that something is going to happen that we couldn't predict like that. The phrase we've used up in front of with clients is “It's not the bus you see that gets you, it's the bus you don't see that gets you.” No one saw the pandemic, people talked about it two years before. I think Bill Gates said something about, you know, preparing for a pandemic, but no one actually said this is what's going to happen to markets and portfolios of people and lives if a pandemic comes. So that was sort of new.
But there were a couple of very simple things we were able to do. Things like make sure you have your emergency fund fully funded. And make sure you're not relying on 12% returns to get your long-term plan to work. Make sure you're relying upon returns that are reasonable. Make sure you're basing your long term assumptions on the sixes, and sevens, or even the fives, not the nines, tens, and elevens. Make sure that in that process you're saving enough and then learn about market history.
Something that I think is unique to us is we give words to this concept of mindfulness. We think that the requirement of sitting still while the market goes crazy around you, is actually our superpower. It's the thing that we think you have to do to be successful through this stuff.
We're always talking about mindfulness now. I can't make somebody meditate or I can't make somebody practice. But we tell people, “Hey, if there's a moment where you can't sit still, call us.” We'll help you sit still, we’ll help you back off the ledge, will help you be careful, be thoughtful. Sitting still will help us look at the portfolio and see this is doing well and this is not doing well really help the client understand that structure.
Scott Jacobs: I totally agree. You mentioned this emergency fund and I get all different derivatives or versions of what people think that actually is. Is it three months, or six months?. Talk to me about what you think is that sort of sweet spot that we run into where people really want to have this money put aside, and it's not for renovation and it's not for a trip. It's for what? It's for emergencies. What's the right mix for families, do you think?
Jonathan DeYoe: I wrote a piece on this five years ago, and it's really a moving target. Imagine this: the kid graduates from college, he doesn't really have any debt. She doesn't have any debt. She doesn't really have anyone relying on her. That person needs a month, maybe two months’ worth of cash on the sidelines. They're easily, quickly re-employed if something happens to their company or the job. So it's really simple for them. They don't need a lot of cash on the sidelines.
Fast forward five, seven years, maybe they have a partner, maybe they're living with somebody. Someone might rely on their income and so maybe they want maybe three to six months of income at that point.
Fast forward about six, seven, eight, maybe ten more years. Maybe they're married. Maybe they have their first child. Then it's maybe a year or 18 months worth of literally accessible, FDIC guaranteed cash in the emergency fund.
As you approach retirement, you start relying upon your assets. You're no longer relying upon an income stream but you are relying upon your assets. Then the stability of those assets becomes very, very, very important, or the access to income becomes very, very important from those assets. So in that case, I would say a minimum of two years cash on the sidelines, because that's roughly what it takes for a market to recover. That's what happened in 2008. Surprisingly, 2020 only took five months. But sometimes, in a bad time, it takes two years to recover. You want to have two years of cash on the sidelines to weather that kind of storm just in case.
Scott Jacobs: What's the best way to speak to too much emergency fund where you just really have too much on the side with inflation and cash? What's that magic formula there for families, you think?
Jonathan DeYoe: We have a couple of clients that have four or five years of cash on the sidelines. And I don't want to take that away from anybody as long as, and here's the catch, as long as you have enough assets invested to beat inflation for a 30-year income stream, 40-year income stream. As long as you have enough that's growing, then you can have a big emergency fund. That's a luxury. It's a luxury to be able to put five years in cash on the sidelines and still have a pool of assets big enough to spin off an income stream that lasts the rest of your life, and is growing with the rising cost of life, lasting until the day you die. It's a luxury to have everything you want in that scenario. So we have clients that have that luxury and that's good for them.
Switching gears here, what are the two biggest misconceptions people have about risk?
Two Common Misconceptions About Risk
Scott Jacobs: So the one that comes up in almost every conversation we have with most families or individuals is that they really believe that the risk is the market going down and never coming back and assets depreciating and never amounting to a retirement plan for them. And what we've been really trying to do is reframe that as the risk of losing purchasing power. Over very, very long periods of time, diversified portfolios of some of the best companies in the world, they don't go down and stay down forever. There's just no evidence supporting that.
I think that's a big one, the misconception that my assets will go down and never come back. You can own a tech stock or an individual company or crypto or something, and that may never come back. But a diversified portfolio that's global, that owns the best of the best, there's no supporting evidence that that will go down, stay down, and never recover. So that's one misconception.
The second one is about inflation. I love having this conversation. I usually ask what was the cost of a bagel, because I'm from New York, or pizza, because I'm still from New York, when you were a child? I ask these questions to whoever I'm talking to. I hear things like five cents, twenty-five cents, fifty cents. And I start reminding them that to put a topping on pizza today is over a dollar, just a topping. And so your dollar today in twenty five years is worth 50 cents. So there's a very legitimate risk of loss of purchasing power. There's this misconception around depreciating assets that never recover and this non focus on the dragon to truly worry about, which is this inflation dragon. And so I think those are two things that we really try to reframe. We want to have families understand and focus their attention and their energy in the right place.
Jonathan DeYoe: I just want to push back a little bit. What if someone is nervous and says “But Scott, markets zig zag. And if I invest money and it goes down, that's really scary.” What is the real risk there?
Scott Jacobs: The traditional decline, going back decades, lasts about 18 months. The risk is for about 18 months, in a general worst case, your assets are temporarily down, declining, depreciated temporarily, and you need to get comfortable with that. And we've had these conversations before. In order to be a successful long-term equity investor in the markets, there's a couple of really important things that need to take place in order to participate in the market's permanent advance. Families, individuals, investors, consumers must be able to stay in the market during those temporary declines that have to happen, or else you can't be invested in stocks or stock funds.
I always have another question that comes up. I always ask, “Do you have any idea what the Dow or the S&P were when you were born?” I love this question because we still run into people that think the market is gambling, the market is a crapshoot, et cetera, et cetera. Not a lot, but it still comes up. And I always remind folks that when I was born and when you were born in 1971, we weren't even a thousand on the Dow. So if it was barely a thousand in ‘71 and now it is thirty five thousand, it's really clear what markets do over a very, very long period of time. Over a long period of time, risk is mitigated.
If someone's really uncomfortable with a temporary decline, they may not be able to be an equity investor in stocks, bonds, and things that can go down. They may have to be in checking and savings and securities of that nature.
The Down Side to Risk Free Financial Success
Jonathan DeYoe: That means they have to save more, they have to put more aside. You can get there with a 0.05% return, it's just much harder. It sounds to me like you're saying embrace markets that go up, embrace markets that go down. The risk isn't that that happens. The risk is that I do something stupid with my money when it's down or I set it up so that I have to draw my income from it while it's down. It's really an issue of behavior, not the market.
Scott Jacobs: I think that's one hundred and ten percent right.
We've had this conversation before so I might as well bring it up. I love the study that Vanguard did. Vanguard did this amazing study for 20 years that basically showed that their Vanguard S&P index fund returned about eight or nine percent for two decades. And then they also did a study around what the investors at Vanguard in that exact fund actually get in their rate of return. And the answer is 2.2%. And so I asked this question often, how is that possible? The answer is investors actually underperformed their own investments. It's not about the investments you own. it's about your behavior and staying the course. I mean, literally, you're underperforming the investments. You actually had such dramatic amounts. To be in something that went up 8 or 9, you're only getting 2.2. You're not even close. So your behavior is critical.
Jonathan DeYoe: Let's talk about some younger investors who weren't necessarily that invested in 2008. Maybe they had a thousand dollars in the market in 2020 so they saw some market volatility and experienced it. But they're thinking “Tech has done so well for the last 10 years. I just want to go all-in on tech and just keep it on tech and keep my foot on the gas and just keep going forward. I know that's how wealth is.” They say, why change? So what do you say when someone comes in with that kind of a message or that kind of response?
Scott Jacobs: Sometimes it's helpful to have current-day examples. And the good news is, since November, we actually have a few now. Companies like Square that used to be 275 went under 200. Companies like Airbnb, which went wildly, well over two hundred. Doordash, cut in half. So things have dropped 20, 30, 40, 50 percent in short order. Snowflake, Pelantir, the list is actually kind of endless. I didn't have this current list six months ago because growth for the last several years has gone bananas and really didn't take a break. It just went. And so the only way to talk to someone who hasn't experienced the trauma and the downturns that we've seen is to try to extrapolate current day so that they can understand what's relatable to them. And the good news is we have some of these examples now. But without those examples, I think sometimes it's hard. It's hard to get across. I know Scott at twenty-something years old was not willing to listen. There's no way. And how could I expect Steve, Lisa, Jennifer, or Dave to listen? I couldn't do it.
Financial Storytelling vs. Data: Two Ways to Understand Your Money
Jonathan DeYoe: This is one of the differences between you and me. When we're talking to people, you have a story, you've got a modern day example. I go to history and I get very analytical. I'm not right brain, I am very left brain. I think there are three time periods. First, there's the long, long, long time period where we know value outperforms. Second, there's like the recent time period of the last ten years where growth has just killed it. That's an anomaly. That's not something that happens a lot. It's not something that happens over a long period of time. It happened over the last ten years. So that's our (top of mind) sample period.
The third period, the current short-term, very short-term value is actually coming back into vogue. Right now, value has momentum. Growth is kind of having a crappy time. No one can predict the six month period or the ten year period, so we just focus on a really, really, really long period and know what works long term. That's where we come up with a plan, appropriate asset allocation, broad diversification, and rebalancing as our core tenants.
I think your approach probably gets people better than my way. But I do think it requires both.
Prediction vs. Planning
Scott Jacobs: I just saw something about this yesterday. JP Morgan puts out a weekly with great data, and what I was trying to get a sense for is, Where is this value vs. growth thing right now? It said that year to date, the Russell value index was up 18% as of yesterday. The Russell growth index? 4. It's getting wider. We're not predicting we're always on the planning side of the equation, but what if you're this growth person, this tech person - if you are concentrated in the Facebook, Apple, Amazon, Netflix, and Google’s of the world - and this persists? You're not at that party. You're missing it. And so, that's why we roll with balanced global portfolios.
I love this part of the conversation, too, that we have with families where we say we're not in the prediction game, we are in the planning game. And we're not going to ever come to you and say we think oil is really inexpensive here. We're going to own more of it, like tech or consumer non durable, if it is cheap. We're not going to play that because that's speculating and it's not being mindful. And there's plenty of folks out there who will talk about a special algorithm or a secret source or what have you. And there's no supporting evidence going back decades that that's what helps your long-term outcomes. In fact, it's the other way around.
Jonathan DeYoe: Going back to how you tell the stories and I bring up the data, if you look at a bell curve this is perfect, right? You look at a bell curve every three year period, there's somebody that's winning and it's not the same person every three years. And that's the key, you're right. Somebody knocked it out of the park. Somebody got lucky. Somebody, but they don't repeat. They don't repeat [that success]. If it's three years, if it's five years, if it's ten years. And that's what's really important to understand and if you understand that, you know to always stay diversified.
Scott Jacobs: I am going to ad lib this. Let me know if this works for what we're doing here. I can probably do it without looking at it, but I have something I may want to put up on the screen share screen for a second. Warren Buffett just had his annual meeting with Charlie Munger, his ninety-four-year-old best bud down in L.A. and I thought one of the things that was so interesting, is that they showed in 1989 the top 20 most valuable companies. And you saw things like Exxon, G.E., Merck, and, Philip Morris, and these companies are dinosaurs today on some level.
Fast forward to now: the Facebooks, the Googles, the Amazons. The point of the story is that it's hard to envision a world where these companies don't dominate, the ones that are dominating now. But the truth is, and this is what made the charts so brilliant, There's no one company in the top 20 that's in the top 20 today. Zero. I get chills saying stuff like this because it's like, wow. We just get so accustomed to what's normal and, you know, present and dominant today. But if history is any guide, there will be other players that show up and this will be a different landscape. So Warren Buffett always brings value and it's all great stuff. I was really surprised at that for sure.
Return to Learn About Portfolio Building
Jonathan DeYoe: This has been great. I think the next time we come down and talk, we're going to talk about how to build a portfolio in kind of a simple way, simple terms. This conversation was about what financial risk is and how do you manage risk? I hope you've enjoyed it. Subscribe and we'll talk to you soon.
Scott Jacobs: Thank you. Take care.
This transcript was edited for clarity.
Want to learn more about financial risk and risk management? Watch the video or check out our financial education courses. And don’t forget to read our next blog focused on how to build a portfolio.
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