Risk VS Volatility

Chances are that you haven't been asked the crucial questions regarding risk and volatility. The right question is, "What does risk mean to you?" rather than the more common "What is your risk tolerance". The Finance industry has successfully blurred the lines between risk and volatility. Financial professionals have made it difficult for individuals who are not well-versed in finance to understand the difference. In my experience, advisors like myself need to do a better job of explaining the proper way to view risk when you invest. If you have ever worked with a financial advisor, you may have encountered this situation.

Let me give you an example of what you might encounter in a typical risk evaluation:

1. Advisor: To help with the allocation of your accounts, I'd like you to complete a brief questionnaire. It includes 6 to 10 questions about your risk tolerance and will generate a score between 0-100 or 0-10.
2. Client: Okay, "jots down anything that appears to be knowledgeable to avoid asking too many questions and feeling embarrassed."
3. Advisor: Excellent, thank you for completing the form. Based on your responses and age, my recommendation is to invest in a portfolio with a 50% allocation to stocks and a 50% allocation to bonds. This allocation will place your risk level in the "moderate" category, and you can expect normal fluctuations in normal markets up to one standard deviation from historical averages. In non-normal markets, such as those seen in 2008, 2018, 2020, and potentially 2022, your risk level may increase to two standard deviations from historical averages.
4. Client: Great, a 50/50 portfolio is what we're looking for. You wonder to yourself; "But how does this translate to my actual situation?"
5. Advisor: Allow me to elaborate. "She pulls up a chart comparing the historical returns of the S&P500 index fund with the advisor's suggested portfolio." She explains that in 2008, if you had invested in an S&P500 index fund, you would have experienced a 38% decline. This moderate decline in portfolio value represents your level of risk. On the other hand, if you had invested in a portfolio comprising 50% bonds and 50% stocks, you would have only suffered a 24% decline. Do you see how much less risk you would be taking?
6. Client: Seems to make sense to me, let’s move forward.

Imagine this same line of questioning – But in this case, coming from your doctor. Please share your thoughts on how you would feel in such a scenario.

1. : Please fill out this 6 to 10 question form that tells me the problems you are having.
2. Patient: Sure thing, throat hurts and I have a headache from all these forms.
3. : Excellent! Thank you for filling out the questionnaire and providing your age. Based on your responses, it seems like you may be experiencing a headache and a sore throat. What kind of treatment or relief do you think would be best to help you feel better?
4. Patient: I'm not sure what I need, that's why I came to you. Could you please advise me on the appropriate prescriptions and actions I should take to feel better.
5. : Regrettably, it's not possible for me to provide my professional opinion on what may be the most suitable option for you. I must consider your thoughts on a subject matter that you may not possess adequate expertise in. Then prescribe the medications you request.

I realize this may sound unbelievable; and while such an approach would be unthinkable in the medical field, it is unfortunately all too common in the field of financial planning. The reality is that the vast majority of investors are not equipped to diagnose their own financial problems; let alone prescribe effective solutions. Luckily, we can seek guidance from professionals to help avoid underfunding during retirement. However, it's important to acknowledge that some professionals in the finance industry may lack awareness about the risks and volatility involved. By addressing this issue, we can work towards ensuring that more families have a secure financial future in their retirement.

When it comes to your finances, different types of risks can affect your investments. Let’s define risk:

1. Risk of loss:
   1. Selling your investment at a lower price than you paid for it
   2. The company you invested in going out of business
2. Risk of over or under diversification
3. Risk of needing your resources and not having access to them
4. Risk of not investing in the stock market.

Let's dive deeper into the risk of loss in the stock market. You may think it's a straightforward concept, but have you ever considered the different ways you can lose money while investing? Would it surprise you to learn there are only two ways to lose money in the stock market: selling your investment at a loss or investing in a company that goes out of business.

But wait "what if I buy 100 shares of XYZ stock at $160 per share and it drops to $120 per share? I've lost money!" While it's true that your account value has dropped, it's only a paper loss. You do not actually "lock in" your losses until you sell your shares. Once you lock in your losses, that is when the IRS sends you a tax form for your gains or losses. The numbers on your screen are just placeholders of estimated value until you sell. They're irrelevant to your actual investment returns until you decide to make it permanent.

How can we address or solve for the Risk of Loss? It's actually quite easy to minimize or even eliminate most of the risk associated with investing in stocks. The first step is simple: do not sell your stocks. Check! That’S it. Is "never sell" synonymous with not rebalancing your accounts? Does it mean that you should hold onto a company even if its core competency has shifted? Of course not. What I'm trying to convey is that you should avoid selling out of fear or due to market news that's being sensationalized. Instead, aim to invest in high-quality companies and hold onto them even if their share prices drop due to market volatility. If you do decide to sell a company, make sure it's for the right reasons, such as taking profits, rebalancing your portfolio, or avoiding overexposure to a single company. These are legitimate reasons to liquidate your holdings.

The second step is also straightforward. You've probably heard the saying, "Do not put all your eggs in one basket." This principle applies to investing as well. To address the Risk of Loss, don't invest all your money in one company - spread your investments out. Legendary value investor Benjamin Graham recommends investing in 10-30 companies. I suggest families going up to around 100 holdings if you have the resources and want a pure stock portfolio. Alternatively, you can purchase an actively managed mutual fund with a high-quality management team. By owning a well-diversified portfolio, you can significantly reduce the Risk of Loss by a large degree.

One of my clients shared a great saying that can help you understand the significance of diversification.

“Regardless of their individual approaches to making money, all financial professionals agree on one thing - the importance of diversification.”

It is hard to underscore just how risky under – diversification can be. Thinking a company is the best and will never lose value is a dangerous trap. This kind of thinking can lead to a portfolio disaster, as demonstrated by the collapses of Enron, WorldCom, and more recently SBV Bank. It's crucial to remember the phrase "don't put all your eggs in one basket." On the other hand, over diversification, which is rarely talked about, means owning too many stocks across too many markets. Not only can it water down great investments, it almost always increases costs, which in turn eats into your potential gains. It's important to have conviction in the companies you own and avoid creating an over-diversified portfolio.

While index funds have marketed themselves well as the cheapest investment option, it's important to note that some actively managed teams have consistently beaten their benchmark over time. Index funds offer two things: to have low fees and to seek market average returns.

1. You will earn slightly less than the “market” when it goes up, but you'll still earn a good return. For instance, if the S&P 500 index rises by 10%, and the fees are 0.15%, your account will go up by 9.85%. Underperformance!
2. When the market goes down, you will lose slightly more than the “market”. For example, if the index decreases by 10%, your account will go down by 10.15%. Underperformance!

I ask, what value does an investor receive if the index fund consistently underperforms when the market rises and falls? In my opinion, having the chance to potentially exceed my benchmark is a valuable opportunity.

Not appropriately planning for surprise expenses is also a risk commonly overlooked. For example, unexpected expenses like AC repair, unplanned vacations you “had” to go on, car repairs, or your daughter's wedding. These "emergencies" can and should be planned for through prudent financial planning. To mitigate the risk of needing your resources and not having access, the CFP Board recommends having two years of cash for "Emergency Funds" for retirees, while well-respected author Nick Murray recommends having five years of cash or cash alternatives. I agree with both, depending on your current financial position. The ideal solution is to have two to five years of emergency funds set aside for known and unknown expenses that have no correlation to the stock market. When working with your financial professional, you can identify the best way to approach this.

In my opinion, the biggest risk of all is not investing in the stock market!

Consider a hypothetical scenario where you are extremely “risk-averse” and invest in a 100% bond portfolio. Over the past 20 years, the Bloomberg U.S. Aggregate Bond index has averaged 3.18% per year, while the Consumer Price Index (CPI) has averaged 2.48% per year. This means that you, as a conservative investor, would have earned a net total return of 0.7% per year after accounting for inflation. Here is the hypothetical scenario in action:

We are going to assume you started with $500,000 at age 45 and saved $2,000 per month for 20 years until age 65. Your investment portfolio would have grown to $1,591,975.85. However, after accounting for inflation, based on CPI of 2.48% per year, your purchasing power would only be $1,088,157.00.

In contrast, if you had invested 100% in stocks, such as the S&P500, you would have earned a return of 10.37% per year over the same period. After inflation, based on CPI of 2.48% per year, your total return would have been 7.89% per year. In this case, your investment portfolio would have grown to $5,931,130.67, leaving you with a purchasing power of $3,368,458.55.

Having a larger pool of resources to draw from is the most conservative approach for any investor. Focusing on total return is paramount. Providing you with greater flexibility and ensuring that you have enough money to last throughout your lifetime.

We have yet to really discuss the concept of volatility, as the industry often confuses it with risk. However, I believe that the two are not the same. Risk, as previously defined, has little to do with volatility. Volatility is defined as the day-to-day, week-to-week, or year-to-year price changes in the market or an individual investment. If you agree with me that risk and volatility are not linked, you have taken an important first step. You will be able to view any market event or sensationalized news story with indifference and ask yourself the only crucial question:

Has my risk level and investment objectives changed or is this simply a temporary phase of higher volatility causing me to want to sell?

If it is the former, you should consider adjusting your cash holdings to align with your new risk level. However, if it is the latter, it's important to remain calm and stick to your investment plan. In fact, given your individual situation, you may even consider investing more to take advantage of the market opportunities that arise from the fear of short-term fluctuations. Remember, focusing on your long-term financial goals is key to achieving the life you want in the future.

Any opinions are those of the author, and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. Every investor's situation is unique, and you should consider your investment goals, risk tolerance and time horizon before making any investment. Investing involve risk and you may incur a profit or loss regardless of strategy selected. Diversification does not ensure a profit or guarantee against a loss. The forgoing is not a recommendation to buy or sell any individual security or any combination of securities. There is no assurance the trends mentioned will continue or that the forecasts discussed will be realized. Past performance may not be indicative of future results. Economic and market conditions are subject to change. The S&P 500 is an unmanaged index of 500 widely held stocks. An investment cannot be made in these indexes. Holding stocks for the long-term does not insure a profitable outcome. Investing in stocks always involves risk, including the possibility of losing one's entire investment. Rebalancing a non-retirement account could be a taxable event that may increase your tax liability.

The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The Consumer Price Index is a measure of inflation compiled by the US Bureau of Labor Studies. Investors should consider the investment objectives, risks, charges, and expenses of mutual funds carefully before investing. The prospectus contains this and other information and should be read carefully before investing. The prospectus is available from your investment professional.