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How you should think about Risk

Summary

We all know the risks, we understand how to think about the pros and cons of a decision. But when it comes to the stock market, are you certain you’re thinking about it the right way?

The risk isn’t that your portfolio goes down in value, the risk is that you can’t reach your goals. What are your goals and when do you want to reach them? When do you expect to spend the dollars that you put into the market today? 

I think about risk as either:

  • You permanently lose money OR
  • You do not reach your goals

If you have long-term goals that require money, the biggest risk you take is not investing in the stock market. It’s one of the safest places to make a long-term investment and not lose purchasing power.


Photo by Cristofer Maximilian on Unsplash

Transcript 

[00:00:00] Mike: Welcome to financial planning for entrepreneurs and tech professionals. I'm your host, Mike Morton certified financial planner and charter financial counselor today. Matt and I discussed the difference between risk and volatility, just because stocks go up and down doesn't necessarily mean that your portfolio is risky and that cash under your mattress.

That might be the most risk you're taking. Enjoy the show.  

[00:00:28] Matt: I'm Matt Robinson and I'm joined as always by Mike Morton of Morton financial advice, Mike.  

[00:00:34] Mike: good man. Doing great today.  

[00:00:36] Matt: I'm also doing great. And for our video viewers today, because there may be some where broadcast at WK Excel, we're available as a podcast and we're on video.

And for our video viewers today, we're playing a fun game. Called. When will the piece of artwork on mats, zoom wall fall down behind him? You can imagine if you're listening to this, what the situation is, there is a very klugey solution to a not very secure piece of artwork behind me. I don't know. It's just a risk that I'm going to have to take.

And speaking of risk, Mike, you made a comment to me that I'm not sure I understand. And maybe you'll flesh it out for me and for our listeners, you said we measure risk the wrong way, and that's a financial thing, which is your expertise. So what do you mean? We measure risk the wrong way.

[00:01:28] Mike: Right. So when we're talking about risk, the risk of things, right? We can think of all kinds of situations like your artwork. That's a risky at the moment.  

[00:01:36] Matt: Very  

[00:01:36] Mike: Um, or other situations, very precarious kids taking risks. When you have young children, you'll be well aware of kids taking on risk in the financial markets there's risk as well.

And let me ask you a question, Matt, uh, I assume in your retirement accounts, you might have a target date.

[00:01:55] Matt: I do. I do have a target date fund.

[00:01:58] Mike: Okay. What do you think is risky about that fund? If it goes up and down that you could potentially lose some money

[00:02:05] Matt: Yeah, history says I won't put probability, says I could. Yeah, that would that would seem like a risk to me that I would actually either lose money or not make nearly the amount of money that I'm counting on for my return.  

[00:02:20] Mike: Sure. So you could lose money, right, Because the markets go up and down. So if you check in next month or next year, maybe you've lost some of the market's gone down and you've lost some money. Right.  

You look at the account balance

and it's gone from, a 1.2 million, matt, down to 1.1 million.  

[00:02:35] Matt: You put the the wrong emphasis on the wrong syllable and you put the comma in the wrong place there, but sure. $1.2 million go for it. Why not?

[00:02:45] Mike: That's a risk. So you thinking about that, but that's not?

the risk map because you haven't lost any money. Your account balance has gone down.  

Your paper value has gone down. The market's gone down. But you haven't lost any money. You haven't cashed out that money. That money is not being spent a year from now that money is going to be spent 10 or 20 or 30 years from now. So what we're looking at there is what you would call volatility. The markets go up and down  

individual stock prices go up and down. They could be more or less volatile bonds. Don't tend to go up and down as much individual stocks are startup companies or venture funds, might go up and down tremendously or go to zero. So that is a measure of volatility and our confusion. Most people think risk and volatility are the same thing. And that's where we get into trouble with thinking about how to think about risks.  

[00:03:39] Matt: I see, is it a time thing? What I'm really afraid of is. I will lose money at the time that I need it. But what you're saying sounds more like I don't really care if I take a meandering road on the way to the destination, as long as I get there. So just because things go down over the next five years or 10 years, it doesn't really matter.

As long as the trajectory is the one I want.  

[00:04:08] Mike: that's right. The way I think about risk is a couple of things. One is the risk of permanent loss. Okay. So you permanently lose that, right? That's one risk. And the other risk is that you are not able to reach your goals and what  

you have framed it.

There is saying, oh in 20 or 30 years, I would like to retire. I'd like to have this pot of money to be able to retire so I can do X, Y, and Z things. Use my resources to enjoy my life, to reach those goals. So the risk to me on the retirement funds, Mike, I'm putting in, a hundred dollars a month, a thousand dollars a month for those that retirement in 20 or 30 years of the risks. That you won't be able to accomplish your goals? Not the path along the way.  

[00:04:48] Matt: I see. That makes sense. Thinking about it more broadly in terms of goals and not about the journey, people always say, it's not about the destination. It's about the journey. Apparently that's wrong. It is about the destination. Not freaking out too much along the way, but that said with that reframed definition of risk.

Okay. Put in the Mike Morton terms, how do I avoid it? How do I make sure that I don't face that way?

[00:05:18] Mike: So there's no way?

of avoiding risks in the sense that there's always trade offs between one risk and another risk. So you want to take on the correct risks in your life. So let me give you an example. We could go to with your retirement funds, we can go to the casino and put it better at all on black.

And we know that we're either going to double our money or go to zero that's one very short term risk.  

[00:05:41] Matt: According to the philosopher, Wesley Snipes, that's actually the right move. A hundred percent of the time. You'll always bet on black,  

[00:05:47] Mike: That's right. A hundred percent of the

time.  

[00:05:50] Matt: It works a hundred percent of the time. Okay. Go on  

[00:05:53] Mike: so that's one type of risk is that short term risk, but  

 Long-term risk. Okay. We could also just stash that. Under the mattress, Hey, you know what, I'm going to need this money. I'm going to stash it under the mattress. So you're not going to bet it. You're not going to invest it. You're not going to bet that money, but the long-term risk is that you're losing purchasing power to inflation. Okay. Just by  

holding on to $10,000 of cash, we know that wages go up, inflation goes up over  

time. And so your purchasing power is going down for that $1,000.  

Of cash. You can't buy as much, when you reach retirement. So that's a real risk. And I feel that most people get caught up in the short-term risks because of the headlines, the volatility that, the news cycle, the economy, it's all very fascinating.

That's what we tune into. So we  

overemphasize. Those short-term volatility as risk. And we underemphasize the real risk, which is that you will not have money you need in the far future.  

[00:06:53] Matt: I think it's a famous NBA, long shooter, who said you miss a hundred percent of the shots you don't take. Now. I've never agreed with that, especially when that shooter is particularly tragic and represents my team. But I see why you're reframing of what risk really is in that regard.

Because if I just stick the money under my mattress, I really do have. I'd almost 100% risk of not obtaining my goals because my money is certainly not going to grow. And it's extremely likely to erode in value. So is that the right way for me as an individual investor to think about risk or how should I, as an individual investor think about risk.

[00:07:36] Mike: Yeah.

that's exactly  

correct. That you want to make sure that whatever goals you have, you have a plan to reach those goals, and take the appropriate amount of risk. Now, if we're talking again, we're talking about retirement a few times here. So things that are far in the future, potentially 10, 20, 30 years, the risk is you don't have the money available.

If you need a million dollar. Say to retire if you can save. And if you think that's accurate, you're projecting out in the future. I need $1 million for, covering for inflation and other things. If you can say 50,000 a year for 20 years, you don't really need to invest that very heavily.

Because that would reach your 1 million. Okay. So you don't need to take on volatility. You know, you can have those in very stable. Funds and savings or checking accounts. Cause you know, you can reach it. So that's a great plan, but if you can only save 30,000 a year and you have 20 years and you want to get to 1 million, then you need to take on some appropriate level of investing in order to try to reach those goals to accomplish what you're trying to achieve.  

[00:08:39] Matt: people are. Not built to think in these terms, because everything you just said makes total logical sense. And I think about it it's easier for me to think about it. Maybe it's because of ties to my own personal situation with a more near term goal. Am I going to have enough money? To send my kid to college, which I'm going to have to do in weld eight years away.

Right. And if I look at the amount of money that I've saved right now, I do not have enough money today. And I'm not putting away enough money each month to reach my goal in eight years. And so as exactly as you just said, I have to take on some volatility. I have to take on what most people would call risk.

But what you're saying is volatility. I have to expose myself to those ups and downs because history and probability says, that's the only way to increase the rate of return. And I'm going to need that rate of return. If I'm going to hit my goal. It's so hard to think that way, because if things go badly it's, we see this all the time in the world.

It's very hard to tell ourselves the story or to explain to other people to explain to my wife. No, No. We had to do things this way because the relative risk of not hitting our goal was high. If we didn't expose ourselves to volatility, then if we did, do you find that, you work with clients on these kinds of things all the time are people resistant to this way of thinking?

Are they able to look at the world this way and be okay with the fact that, you're weighing different probabilities?

[00:10:29] Mike: Yeah,

I think it's a great way of looking at it and what we need to do. A lot of times I couch it in those terms eight years from now, you need these dollars. So what is the most appropriate way? Of investing for those to spend those dollars in eight years or spend them in 20 years. So in your case with a college fund, Hey, we're going to start spending them in eight years. So we want to take on some level of investment, given the history of how stocks perform and bonds perform and what we hope to expect. Maybe getting that five, six, 7% return, but understanding. So when you

look at it an eight years timeframe, you have a different probability of where that money is going to end up. Plus, or minus what we might say, a standard deviation, right? Versus where it might be in one year, if you need that money in one year and our brains are really tied to the one-year volatility. Oh geez. It seems really risky. It could go down 20 or 30%. That's true in one year. But when you need dollars in eight years, then the likelihood of it being down by 20 or 30% are pretty small.

Now the likelihood of it being up only a couple percent.  

Yeah. That's it could be reasonable. The likelihood of it being up 30 or 40%, that might be the average, and maybe, if we get great next set of eight years, it could be even more than that. So when you frame, when are you going to spend the dollars, then what are the probabilities of where it's going to be say, five, 6% per year plus or minus, standard deviations. And that's the way to think about those dollars in the future.  

[00:11:59] Matt: But it's so hard. It's so hard. I, you see this all the time in things like the NBA draft, just to choose a different sport and a different sports metaphor. . You've got, your team has got a high draft pick, and , they've got to decide who to go with and, the reality is.

That you make these selections and at least half the time, they don't work out to the level that you think they're going to. And when they don't work out, everyone, including within your own organization is willing to pile on and say, you made the wrong choice and people lose their jobs and, look, what's the number one thing that couples fight about it's money.

That's the number one thing. And there's just a tendency in sports organizations and I'm sure in marriages to take on less volatility, even if, as you've just demonstrated in a very dispassionate mathematical way, you're better off saying, look, this is what gives me the better upside. This is what the numbers say.

R is going to leave me in a better place in terms of my goals. It comes back to everything you were saying before. If you define what your goal is and that's what you want to achieve. This is the path to get there. Are your clients, are you and your own life able to accept the possibility that you're going to have a bad outcome?

And even if you had a bad outcome, it doesn't mean you made the wrong decision.

[00:13:29] Mike: Yeah.

exactly. That's a tough one. But I think as humans, we often adjust no matter what the courses that we've set for ourselves. So when I'm talking with my clients, we're setting, one year goals and five years or 10 years, whatever timeframe they're in.

We talk about what

money you'll need at different times, and what's appropriate expectations for that money over time. And a lot of times what happens. Is Okay.

If we get some great years, we might end up here. If we get some bad years, we might end up here, but we'll know that in advance. And we'll make adjustments. Now, this is what we do as humans all the time. If the market and the economy is crashing and people are losing jobs and your stock portfolio is down. Are we taking trips, to Europe and taking a few weeks off work. That's just natural. When the stock market's gone up for four or five years in a row, people, you know, their net worth has grown. Are they taking those trips to those times off? Yeah.

they are. So that's just a natural reaction to how you're feeling about your net worth. And the other thing I would say is that your goal. Are tied to your resources. I want to enjoy this way of living in the future or next week, next month or five years from now, I want to enjoy this way of living well.

What are the aspects of that way of living that are really important to you?

Often, if you explore that topic, it's not as tied to absolute dollars as you might expect. So in other words, I really want a beach. Because I want to live right by the ocean. What do you love about the  

ocean? I just love being near the water and the wind and the surf. Are there other ways of doing that? If you can't quite afford a whole beach house that you could take advantage of that there's going to be a myriad of options that you can enjoy the same feelings and sensations and get almost the same or the same value out of it in terms of your life. That don't take nearly as many dollars and we do this all the time.

It's just.  

[00:15:26] Matt: For me, that equivalent would be to pour some sand down my pants, take a walk in the heat and then pour a bucket of saltwater over my face because I'm not an ocean guy. It's interesting because what you just said besides the ocean metaphor does tie to an observation that you made to me, which I find interesting.

Stocks are one of the least risky investments. Why is that? Because stocks are volatile. They go up and down. Why? What makes stocks one of the least risky investments?

[00:15:54] Mike: exactly. Thanks for bringing that up. Matt stocks are one of the least risky when you're looking at the correct timeframes. And so there's some graphs you can try to include in the show notes that again, show you well in 10 years, here's the average radar return and plus or minus standard deviations.

And you'll find that stock portfolios are. Outperforming bonds or just checking or savings accounts because they're tied to the economy, which generally is going up and they're tied to businesses producing products that we enjoy, that you keep purchasing. And so they, that part of the market, the stock market and individual companies and in aggregate index funds of companies tend to outperform well outperform inflation. okay.

So now when we're talking about. Your retirement portfolio and you might split it up again. You have a 401k, you've got a brokerage account. You've got goals for next year. You got a vacation you're saving for, you might have these in different buckets, but that longer term 10, 20, 30 years stocks are by far the least risky investment  

[00:16:55] Matt: I, it strikes me that one of the things that you have to weigh in here is FOMO it's fear of missing out, right? Because the other side of the coin is the temptation to say. With 2020 hindsight usually. Oh, if only I had done this. I would have made this much more money and then you look forward and you say I could be missing out because it's so hard for us to imagine that the bad side, the outcome is going to occur.

And so we can just as easily talk ourselves into perhaps taking off. Too much volatility look, all of that said you put it all in the blender, right? Like human beings are bad at being able to live with the idea of, Hey, just because you had a bad outcome doesn't mean you made the wrong decision. And on the other side, we're all beset by FOMO all the time.

And we just, we see nothing, but like gold-plated outcomes in the future. How. Does an investor put all this together deal with headlines, volatility. What's the strategy here.

[00:18:00] Mike: Yeah.

I think first understanding your own individual goals is a first, a great first step. And the goal is. I want as much money as possible. That's, everybody's first thing like, oh, I've got a pile of money. I want to save as much as I can afford to save. And then I want it to grow as much as possible.

Cause I'd like the most money possible. That's fantastic. But really what are your goals? How are you going to use that resource start really thinking about that? I think that's the most critical thing, because again, you can find when you start defining. What you want to accomplish in life. What's important to you, whether it's in work, your family, uh, volunteering, giving back, whatever's important to you.

If you start writing that down and then putting it in a timeframe, you can start accomplishing those things. Once it's in that timeframe, understanding, this is what I'm interested in doing. This is where I'd like to go. And. Start getting more and more comfortable with that, which takes time. Then you can start tuning out all the other noise, because you will understand that you have a perspective for this is what I want to do. And so now you're reading these other things with that new understanding. Now that doesn't really pertain to me because I know where I'm headed. Um, and so that's a great way of starting, but the rest mat is like everything else. This it's setting up your environment for success.

Okay.

Do you really need to watch CNBC every day? Do you really need to, check your stocks, uh, every day, just to read the headlines just under even understanding that those headlines are

there to grab you, to manipulate you emotionally, to read more on that website, click more. That's going to go a long way and whatever you can start cutting out on that front, I guarantee you it'll start feeling better.  

[00:19:44] Matt: That really does connect to all of the longstanding advice here, which is take the long-term view, stay laser focused on that and ignore the noise, which  

[00:19:55] Mike: well, let me  

say this too. We do talk about the long-term view and we've mentioned retirement a number of times, and this is super boring for everybody, Matt. Yeah. But who cares 20 years from now? I care about what I'm doing next month. There's so many things that you can do again with goals.

Just say, what do you want to do next month? What, how do you want to feel six months? What do you want to look  

back one year from now and have accomplished just one year?  

Do you want to look back and say, wow, I'm so proud. I did this thing. I accomplished this thing. Whether it's family work, whatever it is that you're interested in, we don't have to always take the long view.

We don't always have to save tons of money for different things. We can have experiences and do things to accomplish and feel great in the very immediate future.  

[00:20:38] Matt: What I like about your. Closing comment there is that it's sort of like Neo, it's not really about the spoon. Don't think about the spoon. It's not really about the finances. It really is about the goals. Mike Morton. My goals for this episode were to understand how to measure risk the right way and to avoid getting hit on the head by a piece of my child's artwork.

I think we've accomplished both. Thank  

[00:21:01] Mike: congratulations.

Thanks for joining us on financial planning for entrepreneurs. If you like, what you heard, please subscribe to and rate the podcast on Apple iTunes, Google play Spotify, or wherever you get your podcasts. You can connect with me on linkedin or mortonfinancialadvice.com. I'd love to get your feedback. If you have a comment or question, please email me at financialplanningpod@gmail.com. Until next time thanks for tuning in