Home Radio Segments Guest Segments Do You Understand The True Nature Of Risk?  Learn It Here

Do You Understand The True Nature Of Risk?  Learn It Here

Jonathan Clements, True Nature Of Risk

With Jonathan Clements, Founder and Editor of HumbleDollar.com and Personal Finance Author

Jonathan Clements is the founder and editor of Humble Dollar and a prolific author. His latest book, “From Here to Financial Happiness: Enrich Your Life in Just 77 Days” offers tips and tricks to bolster your personal finances. This week, Jonathan and Steve talked about investing and understanding investment risk.

Risk Tolerance And Risk Capacity

Steve opened their conversation by pointing out that, “investment risk is often misunderstood.” Most people have experienced some level of risk over the past month or so because of the coronavirus pandemic. But, as Steve said, “We need to be asking ourselves some important questions, such as what exactly is risk and how can it be measured.”

Jonathan helped to simplify things with two terms that financial experts typically use when discussing risk. “Financial experts distinguish between risk tolerance and risk capacity. Risk capacity is our objective ability to take risk. If, for example, you have a stable job and many years before retirement, you can objectively take on more investment risk. A large percentage of your portfolio can be invested in the stock market.”

The issue, then, is “how much risk can you take before you freak out”, as Jonathan put it. That, in a nutshell, is risk tolerance. How much risk can you tolerate before you become unsettled or uncomfortable. Jonathan said, “Some people are perfectly happy watching their stock market investments drop 30 – 40%. Other people will lie awake at night worrying about the end of the world.”

Steve noted that, in most cases, you’re making your investments when the market is doing well or is at least neutral. “You generally have this feeling that the markets will rise. In most cases, you understand that recessions happen and that markets fluctuate. But it becomes a totally different situation when you’re invested and the markets are down double digits, and everything seems chaotic. Your emotional risk tolerance changes.”

Behavioral Finance

Jonathan explained that the concept of emotional tolerance in regard to risk is largely covered by behavioral finance studies. He said, “Behavioral finance looks at our mental and emotional mistakes that we make when markets are both up and down. If the market is up and we make gains, we tend to extrapolate them into the future, wishfully imagining that share prices will rise indefinitely. The more we are successful, the more we think we have an expert handle on investing. As our confidence grows, we begin to take on ever more risk.”

But consider the past few weeks. The coronavirus pandemic emerged, and the market responded drastically. Share prices dropped and the market tanked seemingly overnight. Jonathan continued, “Most people in this situation tend to freeze. They don’t buy or sell, but simply stick their head in the sand, hoping things will pass, without looking at their account statements.” But as the plummeting market continues, some investors commit what Jonathan calls the “cardinal sin”. “Fear makes them panicky. They’re worried about their nest egg, so they sell out close to the market bottom. They lock in their losses, forfeiting tens of thousands of dollars.”

Jonathan shared his view on a standard for good behavior during a market decline. “It’s optimal to try to invest more when the market is down. Try to rebalance your portfolio. Take your tax losses and then use the proceeds to make stronger investments. If you’re not able to do this, at least don’t pull out of all your investments. Freezing isn’t the best option, but it’s better than cutting and running.”

Steve jokingly suggested that perhaps our investment portfolios should be put in quarantine just like we are.

Risk Tolerance Questionnaires

Steve turned the discussion to the risk tolerance questionnaires that brokerages have people fill out when they open an account. There tend to be a lot of different opinions among those in the financial industry, specifically brokers and financial advisors, about the efficacy and accuracy of these questionnaires. Steve pointed out that, “They tend not to work because feelings and thoughts on investing change over time.”

One question that’s typically asked is “When will you need the money you’re investing?” which is a fair question. Jonathan’s opinion is that “If you have money that you’ll need to spend in five years, regardless of the reason, that money shouldn’t be in the stock market. It really should be invested in super conservative investments, like high-quality short-term bonds, certificates of deposit, or high yield savings accounts. You shouldn’t be taking any real risks with that money.” Steve added, “And if you’re retired and know you’re going to take income from your portfolio, you need to have a good cushion of non-equity investments in order to draw from when your equity investments are down.”

But these questionnaires also ask a lot of hypothetical questions about how you will respond to market movements. The biggest issue with hypothetical questions, as both Steve and Jonathan agreed, is that you generally say you’ll respond in the best possible way, but it’s virtually impossible to know if that’s really true. “It’s enormously difficult to imagine – when faced with the reality of a plunging market – if we’ll sell, sit tight, or buy. Until you’ve lived through some market declines, I don’t believe you can honestly say what your true risk tolerance is,” Jonathan said.

Steve added, “Most people aren’t really in touch enough with their thoughts and feelings about their investments to answer most of the questions on those questionnaires. In truth, I think the questionnaires are really more for investment companies, to protect them from legal liability in the future.”

Advice For Investors

Steve asked Jonathan to offer some general advice for investors. Jonathan recommended that “Anybody new to investing should start out by being more conservative than they are initially inclined to be. Start conservative, figure out what your risk tolerance is from experience, and then you’ll know how to invest.” This goes back to the idea that until you’ve lived through at least one major market decline, you don’t really have a good idea of what your risk tolerance is.

You can get more personal finance and investing tips from Jonathan at humbledollar.com.

Disclosure: The opinions expressed are those of the interviewee and not necessarily of the radio show. Interviewee is not a representative of the radio show. Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances. The information contained herein was obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by the radio show.

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Steve Pomeranz: I’m very happy to welcome back Jonathan Clements. He’s founder and editor of the HumbleDollar website. He’s also author of a fistful of personal finance books including From Here to Financial Happiness, and How to Think about Money. And I asked him to join me today to help us define investment risk and appreciate its true nature. Hey, Jonathan, welcome back to the program.

Jonathan Clements:  Hey, thanks for having me on, Steve. I really appreciate it.

Steve Pomeranz:  Sure. Now, investment risk is often misunderstood and it takes times like these to get to the root of it so we can make the right decisions about our money going forward. Now we know that we’ve all gotten a taste of what risk feels like over the past few weeks, and it brings up the question of what exactly is risk? How can it be measured? And what should we expect from the outcome of taking more risks, Jonathan?

Jonathan Clements: Let’s start with two notions that you hear financial experts discuss, and I think it’s a really useful distinction. Financial experts distinguish between risk tolerance and risk capacity. So risk capacity is our objective ability to take risk. So, if we have a stable job but we’ve got decades to retirement, we can objectively take a lot of investment risk. We can put a large percentage of our portfolio in the stock market.

The problem is, even if we have a high capacity to take risk, we may have a very low tolerance for risk. And when we’re talking about tolerance for risk, it’s really a subjective issue here. How much risk can you take before you freak out? That essentially is risk tolerance. And some people are perfectly happy seeing their stock market investments drop 30, 40% and other people will lie awake at night worrying about the end of the world.

Steve Pomeranz: A lot of decisions about how to place your money are made when times are either benign or good, you see the market’s rising or you generally have this feeling that markets will rise. You also may generally know that recessions happen, markets go down, and maybe you’ve ridden one or two of them, so you have a pretty good idea. But when you get into the heat of the battle and markets are down double digits in one day and it seems like things are just totally chaotic and out of control, your tolerance, your emotional tolerance for risk, changes. Now, take us through that change, Jonathan.

Jonathan Clements: So these issues have been pretty thoroughly explored by experts in something called behavioral finance. Behavioral finance looks at the mental mistakes we make both in up-markets and in down-markets. So when the market is going up and we take those gains, we extrapolate them into the future, we imagine share prices will rise forever. As we make money, we attribute those gains to our own brilliance. We start to think that, wow, we really know what we’re doing. Our confidence grows and grows. We start to take ever more risk.

And then, suddenly, a pandemic turns up. And share prices start to decline and all of this goes into rapid reverse. We lose that self-confidence, we’re suddenly unsure of what we’re doing. We see our portfolio falling in value. We watch the market coming down and we go, “Oh, my goodness, it’s going to zero. This nest egg I’ve built within a few short weeks is going to disappear down a black hole and I’m going to be broke.” Most people in that situation simply freeze. They don’t buy, they don’t sell. They just stick their head in the sand. They don’t look at their account statements and they just close their eyes and wait for it to all be over.

But for some minority of investors, it’s just too much. And they commit what is probably the cardinal sin of investing, which is they sell close to the market bottom. They get out, they lock in their losses and they say goodbye to tens of thousands of dollars that they will never see again.

Steve Pomeranz: Yeah. I’ve been saying that there are two things that should be quarantined right now—our bodies and our portfolios. You put your portfolio into quarantine. That doesn’t mean you can’t take something out of it and replace it with something else if necessary, of course.

But generally speaking, this idea, maybe the freeze, maybe the deer in the headlights effect, is a positive for some people. What do you think?

Jonathan Clements: I think you’re right, Steve. I mean we know what good behavior is during a stock market decline. Good behavior is you try to invest more in the stock market, you rebalance your portfolio, you take tax losses and then take the proceeds and reinvest into other stock market investments. Those are good behaviors during a stock market decline. But if you can’t get yourself to act well, at least don’t act badly. And simply freezing your portfolio and not doing anything isn’t the worst way to behave.

Steve Pomeranz: Right. A lot of people who have brokerage accounts, whether they be of the discount broker variety like the Fidelitys and the Schwabs or they be the stockbroker variety, have to fill risk tolerance questionnaires. Now I know you have opinions about them. I was, I’ve been using, I’ve been investing for over 40 years as a professional, and I stopped using these tolerance questionnaires about 25 years ago because I found they didn’t really work. They don’t really give you any information, because of what you just mentioned. The fact that feelings change over time and most people don’t really know. They’re not really equipped to make the kinds of decisions that risk tolerance questionnaires ask.

So I’d just like to go through some of these questions here and get your opinion on them. First of all, they will ask you, when are you going to need the money? And you may say, well, less than a year or five to 10 years. I think that’s a pretty valid question. Would you agree?

Jonathan Clements: Yeah, I would agree with you, Steve. I mean, if you have money that you’re going to need to spend in the next five years, whether it’s your emergency money or it’s your next five years of portfolio withdrawals once you’re in retirement, that money should not be in the stock market. It should be in super-conservative investments, maybe high-quality short-term bonds, maybe certificates of deposit, maybe a high-yield savings account. You shouldn’t be taking any more risk than that. So, yeah, that’s a perfectly valid question.

Steve Pomeranz: And that means that if you’re retired and you know you’re going to take income from your portfolio, you need to have a good cushion of non-equity investments in order to draw down from for when your equity investments are down. This will help you keep your head straight. So that’s a good question. No problem with that question.

And then it asks, so here’s a question that I have some problems with. This is from a Vanguard questionnaire, by the way. From September 2008 through November 2008, stocks lost more than 30% of their value. If I owned a stock investment that lost about 30% of its value in three months, I would sell all my remaining investments, sell some of my remaining investments, hold onto the investment and sell nothing, or buy more? Now, what do you think of that question, Jonathan?

Jonathan Clements: Well, Steve, if you asked me if I was walking by and I noticed a house was burning and that there were people inside I could save, hypothetically, I would run in the door and save them. But if I was actually walking past a house and it was actually on fire, I think I would think twice about running into that burning house.

Steve Pomeranz: Yeah.

Jonathan Clements: So similarly, you can ask people hypothetical questions about how they would behave and, of course, they’re going to say, “Yes, I will behave well.” But when you put them in that situation, they may not act as well as they might imagine. And that’s true for all of us in all kinds of situations. It’s just enormously difficult to imagine when we’re faced with the reality of a plunging stock market, whether we will sell, sit tight, or buy. And until you’ve lived through some market declines, I don’t believe you can honestly say what your true risk tolerance is.

Steve Pomeranz: I think that most people are not really that in touch with those kinds of thoughts and feelings to be able to answer questions like that. I think these questionnaires are more for the companies that use them to protect them from legal liability in the future or something of that nature. But in reality, I think they do more harm than good.

For example, they’ll ask you to pick from a group of allocations— 10% stocks, 90% bonds, all the way through the spectrum to 90% stocks and 10% bonds. And they’ll say, on average the decline in worst cases have been X and the return has been Y, the average return over time. Pick one. And I think that reflecting this idea that it’s all so hypothetical, I think that the idea of actually asking even myself to pick one which would be better is misleading. What do you think about that?

Jonathan Clements: I agree with you, Steve. I mean, again, it’s partly because it’s totally different when you experience it, but also nobody in the history of the world has ever gone to the shopping mall and spent a percentage. When we go to the shopping mall, we spend dollars.

And so it’s one thing to say, “Oh, yeah, losing 30%, no problem.” But when somebody says to you, “Your thousand-dollar nest egg is now worth $70,000. That money is gone. It may never come back.” How are you going to feel? Suddenly it becomes a whole lot more real. And maybe you would freak out and-

It’s so hard to gauge how we’re going to react in any particular situation. And moreover, let’s just go to today. It’s never just that the stock market is going down. There’s always some reason for a big market decline. And today, we’re not just fearful because our investment portfolios are worthless. We’re fearful because we may be about to lose our job. We are fearful because we or members of our family or our friends may get this horrible disease and end up dying. I mean, there’s fear piled on top of fear here.

Steve Pomeranz: That’s the idea that this fear piling on fear turns into an irrational conflagration in your brain and makes it very difficult to know what to do and to even know who to trust and who to believe. I think that’s the big problem. So I guess doing nothing turns out to be the final decision. But nevertheless, this idea of actually going through it.

So what’s your final advice for those who have to pick an allocation and then have to live through their decisions when bad things happen? Final words?

Jonathan Clements: I would advise anybody who is new to investing to start by being more conservative than their initial inclination. Because the fact is until you’ve lived through a market decline or maybe more than one, you simply don’t know how much risk you can tolerate. And you don’t want to be in that situation where the market is down 40%, and you’re bailing out of stocks because you’re so panicked. So start conservative, figure out what your risk tolerance is from experience, and then you’ll know how to invest.

Steve Pomeranz: And remember, you’re going to suffer from FOMO, fear of missing out. When the markets go up, you’re going to probably kick yourself that you weren’t more aggressive. But always remember the other side of the coin. Jonathan Clements, editor of HumbleDollar website, which I really recommend this website. It’s great commentary. Jonathan’s got a lot of experience as editor and journalist, and you definitely want to follow him on a regular basis. That’s the HumbleDollar website. Jonathan, thank you so much for joining me today.

Jonathan Clements: It’s been my pleasure, Steve. Thanks so much for having me on.

Steve Pomeranz: Thank you.