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Date: October 26, 2020

Risk Tolerance: Don’t Be the Thanksgiving Turkey

Going for high investment returns without considering the price you’re paying for the value you’re getting is like buying a used car sight unseen – you might luck out, or you might get stuck with a costly lemon.

Risk tolerance is an important consideration in investing. Understanding risk and your reaction to it is key to making wise investment decisions.

Otherwise, investing can be a lot like jumping off a 20-story building, and 18 floors down, yelling, “So far, so good!”

As the above analogy shows, it’s easy to be lulled into a false sense of security that masks your true risk tolerance.

What Is Risk?

At Opus Wealth Management, we describe risk in terms of permanent loss of capital. Unfortunately, a lot of investors don’t see past short-term stock price volatility and react without considering if the underlying fundamentals of an investment have actually been harmed.

It’s easy to earn a high return if you ignore risk, especially during bull markets. It’s much harder to earn good returns while controlling how much risk you’re willing to tolerate. You have to ask yourself how you’ll react when economic conditions deteriorate and stocks plummet.

There are actually two types of risk:

  1. The risk of losing money on an investment
  2. Missing the opportunity to put money into a winning investment

For many, the first type of risk is the more painful, but both can cause you to fall short of your required returns. These two risks are omnipresent and must be balanced.

 

Contact Opus Wealth Management to see how our disciplined investment strategy can help you minimize blind spots and achieve your goals.

 

People Get Sedated the Longer a Bull Market Lasts

A bull market climbs a wall of worry. But as the bull market extends over long periods, that capacity to worry may go dormant. When you see a market rising with relatively manageable pullbacks, it’s easy to let down your guard against risk. The problem with this kind of sedation is that bear markets move fast and ferociously. Your claim to be a long-term investor will be put to the test as you see your paper gains turn into paper losses.

Unfortunately, many investors buckle under the pressure of a bear market, often at the bottom of the market. Whether it’s a loss of confidence, a need for cash or a series of margin calls, the risk of locking in your losses during a bear market is substantial. And let’s face it: Selling at the bottom can cause both financial and psychological wounds that take a long time to heal.

Panic is an ironic response to falling prices. The truth is that as price levels fall, assets become less risky because more pessimism is baked into the price, and the less the future is likely to disappoint. Failing to understand this basic tenet of risk leaves many investors making hasty decisions that compromise their wealth.

As Sure as Night Follows Days, Booms are Followed by Busts

You only have to glance at a 100-year stock index chart to see the processions of booms and busts. One can make gross observations, such as that bull markets last longer than bear markets, but bear markets move faster than bull markets. The fact is that each bull and bear cycle is unique to its time. When markets are growing faster than fundamentals for a period of time, probabilities start stacking against you. In terms of risk, it’s wise to remember that a market making new highs can continue to do so. The same applies to markets making new lows. Until they don’t. Nobody knows when the music stops, but you’re getting closer to the end of the party.

As Warren Buffett once said: “The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money.”

A good indication of risk denial is the phrase, “This time it’s different,” especially when applied to a bull market. There may be flashing red signals that a market is vastly overvalued, but there is always someone ready to explain how the old wisdom no longer applies. As the market rises, risk rises with it, but many investors fail to comprehend the risk and/or think that they will be able to jump out quickly at the top of the market.

Remember, trees don’t grow to sky.

Nothing is more common than a bubble based on some new technology. Over history, we’ve had Canal, railroad, radio, cars, planes, Internet and on and on. But one thing technology never does is change the law of finance.

I can’t help but recall the story of Nassim Taleb’s turkey problem:

You’re a turkey on a farm, and every day, a very nice man comes to feed you and pet you. Every day reinforces the fact that this man loves you and will take care of you, and as the years go by, there is no doubt in your mind. The only problem is you’re unaware of two facts: You’re now the fattest turkey on the farm, and tomorrow is Thanksgiving.

The most dangerous investments are those that have looked wonderful for a long time but where a structural issue is looming below the surface.

Looking to the Recent Past to Confirm All is Well is What Will Get You in Trouble

Bear markets break a bull trend. This means that the recent past trend is obliterated by a brand-new trend. If you haven’t adjusted your exposure to the growing risk as the market runs higher, then you are much more likely to be disproportionally hurt when the bear market arrives.

The predominant bull trend exhibited by recent past gains causes new investors to demand higher returns, despite often-stretched valuations. As prices increase relative to fundamentals, the odds of a negative outcome become more likely. That’s the right way to conceive of risk, and it should inform your portfolio makeup.

Diversification is important, but only to the extent that it is effective. That is, your diversified holdings should respond differently to current events. Your appreciation of risk should lead you to allocate your assets into weakly and negatively correlated markets, such as stocks vs. bonds and bonds vs. gold. This is part of bearing risk sensibly, meaning being aware of risks that you can analyze and diversify away. You should insist on being amply paid to assume higher risks. If you’re properly diversified, you should almost always have some investments doing well and poorly at the same time. If you have all winners, you’re likely not diversified.

Distinguish Between Volatility and Permanent Impairment of Capital

Again, at Opus Wealth Management, we view risk as a permanent loss of capital (a very common definition among value investors). Thinking of risk as volatility is dangerous, because you can have something with a lot of risk that is stable (like mortgage bonds in 2006) or you can have something very safe that has a lot volatility (like a company with good fundamentals whose stock just dropped 50 percent but is trading for stupid-cheap valuations).

The average investor doesn’t look past the price to inform their risk. But price is what you pay and value is what you get (over the long term). People see an upward trend like the “glamour” stocks of this era and think they are not risky because “they’ve been doing well,” not realizing that in many cases, fundamentals have not kept up or are downright awful.

If you’re not sure you’re taking smart or appropriate risks today, schedule a free assessment with Opus Wealth Management and see what we can do for you.

Loic LeMener
Author:

Loic LeMener

Loic LeMener, CFA®, MBA, CFP®, is the founder of Opus Wealth Management.