The Call Is Coming From Inside The House – Assessing Real Risk

The Call Is Coming From Inside The House – Assessing Real Risk

January 28, 2021

I recently had a COVID test with my two young kids. They had a lot of fear and anxiety going into the test, visualizing a swab protruding into their brains for minutes on end. Of course, the test turned out to be a nothing burger, and within seconds we were all literally laughing at how easy it was. This is a great lesson in how our minds are often our worst enemies.

Nothing could be truer than in the world of investing. We create all sorts of worst-case scenarios in our heads, and to ‘do something’ about these imagined scenarios that have yet to happen – and likely never will - we take action in the moment that feels good (and gives us a sense of control) even at the potential cost of a worse financial future.

When we are thinking about the risks that are out there in the world – financial or otherwise – the one that rises above them all but that never crosses our minds is…wait for it… us. Indeed, most investors are their own greatest risk.

Try this as an exercise: create a matrix with high risk for bad investment outcome being on the top left box (X axis) and low risk being on the top right box; high personal control on the top left box (Y axis) low control on the bottom left. Stocks over the long term fall squarely into the lower right box: low risk of potential bad investment outcome and low control. As in, you have no practical control over where the broad market will go today, and over long periods of time, the risk of capital loss for stock ownership is extremely low. Indeed, if you take any 15-year period (starting with any year beginning in 1973), there have been precisely zero of such periods with negative returns, the worse being a positive 3.7% return. If you are reinvesting dividends or adding to your account, then your returns would be even higher. Suffice it to say, when you maintain an appropriate long term time horizon for stocks and as long as you don’t make basic mistakes (like selling in a panic) the probability of positive returns (and thus your risk of money loss) drops to virtually nil and throughout that period, you had precisely zero control over day to day market swings.

Yet people act as though stocks – and their own ability to do something about them - are in the upper left quadrant (high risk, high control). Because investors spend so much time fixated on something over which they have no control (short term price movements) and not themselves (their own behaviors, specifically their emotions around money and how these emotions often work against themselves), they often don’t get the benefit of stocks inevitable gains over time. Instead, they make unforced errors, taking on true risks like the following:

Concentrate risk: How much of any one stock we own.

Leverage risk: Buying something via borrowing versus paying solely with cash. This risk reared its ugly head during the 2007 – 2009 financial crisis in the form of excess real estate borrowing and reoccurs each time stocks go down and force those on margin to sell securities in a panic – and just at the wrong time.

Price risk: Overpaying for a given security. A company can be a good company but a bad stock if valuation metrics are excessive. This occurred in the late 1990s when even great companies like MSFT saw essentially no positive returns for the 00s as P/E ratios declined from 40X+ to more reasonable 20X, causing the stock price to go nowhere even as earnings increased.

Volatility Risk: The main form of risk that is discussed in the financial press is that of day to day price movements, AKA volatility. But short-term price movements only become a source of risk when investors turn what was intended to be a long term holding into a potentially short term one. This is not because their time horizon shortened, but because fear of near-term declines has turned, what very likely still is a perfectly fine long term investment, into a short term source of fear and anxiety.

The reality is that you have control over all of those so called risks (with volatility the form of control is putting cash aside for near term needs and only investing in stocks for funds you don’t need for years to come), so they should never be a form of risk at all. The ultimate form of risk in anything in life is not knowing what you are doing, which falls squarely onto the investor’s own shoulders, as much as he or she wants to place blame elsewhere. Unfortunately, we put very little investment of time or attention in making sure to mitigate the risks within ourselves.

I would encourage everyone as we head into 2021 to assess your real investment/financial risks and consider investing some time into the ultimate form of investment: yourself. A good Financial Advisor can help you not only identify and plan for future financial goals, but also weaknesses within yourself and how to set up structures and systems to minimize any potential damage which in-the-moment emotions-based actions might do to your financial future.