Transcript:
Easan Arulanantham:
Yeah, another common question we have in a lot of our meetings is, how much risk should I be taking on? You know, what, you know, what should my allocation be? You know, how much stock? How much bond? It’s a, you know? And it’s a very, it could be a very personal question, or it could be a very pure number question.
Tom Vaughan:
Yeah, this, this is, this is another one they get asked at the parties or the street party, or whatever it is, you know, how much stock should I have, you know, long term and people look to us, it’s kind of fascinating as for, you know, well, you just tell me what I need. And actually, we have to kind of turn that back around. Because, really, we have to look at you or the client and say, Okay, how much risk can you afford. And so that’s where it kind of starts, there’s two parts of risk, as far as I’m concerned, number one is the amount of risk that you have to take to accomplish your goals, we can figure that out in the financial plan, they can figure out pretty much exactly or at least within a range of how much money you should have in the stock market to make sure that your probability of success when we run that Monte Carlo simulation is adequate. And, but nobody really pays that much attention to their financial plan when the market is caving in, like it did in 2008. And so it’s much more important to identify the risk level that you can kind of afford emotionally. And that’s different for everybody. Again, that’s a little bit like a fingerprint. I’ve gotten it, a lot of people think it’s age related, it is a little but not completely, I’ve have some older clients that are super aggressive, and some younger clients that are super conservative, so has a lot more to do with just outlook, situational outlook, those types of things. It doesn’t even have that much to do with how much money you have. Because I I’ve heard that a lot too. Oh, well, those people must have a lot of money. That’s why they’re taking that risk. You know, that’s not true. I’ve seen all kinds of asset levels, and different, you know, strategies for sometimes people a lot of money have a lot to lose, they can be more conservative, you know, than somebody with smaller amounts. So it’s, it’s much more, it’s just a personal thing. There’s nothing wrong with the way you feel about risk. That’s the right way to feel. It’s the way you feel.
Easan Arulanantham:
It’s much more emotional reaction when I lose $10. Versus if you give me $10, we have very different reactions. And like losing $10 is way worse in that game that you got from gain that $10. So we’re a lot more loss averse. So we kind of that’s why we focus more on the losses when we talk about risk.
Tom Vaughan:
And that’s exactly it. And you’ll see that in the chart. If you look at the charts, they kind of have a sloping, you know, slowly sloping upward motion. And then they kind of sometimes have a cliff on those downsides. And that is because those losses are more painful. It brings in fear. Fear is a more strong as a strong emotion. And so we want to focus on that fear up front, trying to get you to feel a little bit of that fear, and identify some of that, so that you can kind of see what happens. So one of the ways we do that, and I’ll share this with you, is just to take a look at historical returns for different mixtures, and really kind of focus on that worst year, for example, and get you to internalize that and imagine what that would be like, right? So this is from Vanguard, they have some great stuff. And this is really a great one here. This is going back 1926 to 2020. I mean, it’s a really great long term. And 20% stock 80% bond, right, so kind of conservative, and you know, the average return, you can see a 7.2 Not bad. Again, long term, best year is 40.7%. In 1982, worst year is negative 10.1%. And it had 16 losses out of the 95 years that they’re covering. That’s not too bad, actually. And so what we’d be talking about here, though, predominantly, is that kind of worst, your timeframe, you got to be a little careful here because 1931 was the Great Depression. Maybe we don’t have another Great Depression, your life’s lifetime. Yeah, be careful to be too conservative, but it’s still informative to me. So I would take your basically, you know, the amount of money that you have invested and say, Okay, let’s talk about this in dollars. So you got $100,000 All right, good. So 10% What would How would you feel if the 100,000 was now worth 90,000? You know, would that make you panic or not, you know, let’s say you have a million dollars and drops 10% What would you feel if that was worth 900,000 statements?
Easan Arulanantham:
It’s a lot harder when you emotionally when you see like a years where the salary kind of just disappear versus you know, a couple of weeks of salary, right? And that’s like you have that gut feel that emotional reaction is so much Stronger.
Tom Vaughan:
Yeah, exactly right. And so you know, the key is being able to kind of find a portfolio that you’re comfortable with. And one of my other pieces that I always try to bring through to the clients is that sometimes it’s a lot easier to deal with risk when you know what can happen. So for example, with this portfolio, if you thought the worst that can happen was a 5% drop, and all of a sudden, it drops 10%, you’re going to be pretty concerned, because that’s exceeding your expectations, right? And so setting those expectations, and the, this is an analogy I’ve used lots of times, I still love it, you’re walking down a dark street, there’s this tall hedge in front of you, right? And somebody jumps out from behind that hedge, you’re scared, you’re going to react, you know, your adrenaline’s going and what have you, that’s a little bit like not knowing what’s going to happen your portfolio that all of a sudden, it drops, and you’re panicking, versus walking down that same dark street got that same hedge, except one difference, you know that there’s a person behind that hedge that’s going to jump out at you. Not nearly as scary. Yeah, right. So when you know how much it could drop. So we use a thing called Riskalyze, a company that comes in and analyzes our portfolios from the outside, they send our clients every quarter, a report that shows you know how much that portfolio theoretically could drop and say, the great recession that we just had. And so there’s, you know, some we’re hoping that people are able to internalize quarter after quarter after quarter, how much risk they’re taking. And again, that’s just pointing out the guy behind the hedge over and over again. So that when it does happen, you know, so this year, the S&P 500 is down from its highest, its lowest point 14.6%. You know, which is kind of a normal downturn, but hopefully, it helps. So okay, well, this is what happens. If I want that 7.2% average return, I gotta go through these downturns. Right. And so just to give you some examples here, so here’s a 40% portfolio, right? higher return average 8.2. I know, it doesn’t seem like much 1%. But it’s amazing what 1% does over a long period of time. It can. It can and so this has a worst year again, 1931. Bad year, obviously, down 18.4%. Okay, so what’s that mean? What’s the dollar amount to you? How does that work for you? How does that feel? You know, for you, as far as that goes? 60%, which is our most common portfolio? Again, you know, 26.6% downturn, how does that feel? Most of the times it’s up 22 times down nine out of 95. So that’s good. That helps. But again, higher rate of return 9.1 here, and then you know, of course, 80%. Now you get into a negative 35%. downturn. And then, of course, the big 100% stock, right, negative 43. Again, 1931, horrid year for the stock market.
Easan Arulanantham:
But yeah, you’re starting to see, though, be having more stock, you have more years with a loss. And so you can kind of see, there’s more volatility. And so you get an exchange for that volatility and risk that you take on, you get a little bit more return. But you have to be able to stomach that risk. And some ways to stomach that risk is, Do I have enough cash? Do I have a strong financial plan I can stick to. And you have to also remember, like, you guys, sometimes take a breaths and not let your emotional side get to it and kind of take a little step back. Because you’re in the long haul. You don’t need sometimes, if you’re it 45, and it’s your retirement portfolio, and you don’t need a 65. Should I be really freaking out? I lost a lot of money here. But I can’t access that money. I don’t need this money now.
Tom Vaughan:
Yeah, that’s right. So how long until you need the money factors? In some, you’re right, though, some people kind of talk themselves into a frenzy, when really, when they look at the reality, sometimes that helps, right? The other thing we talked about that really helps is to the structure of your overall portfolio, how much income do you have coming in, that aren’t affected by the stock market? And then really, you know, how much money do you have set aside? You know, if you’re going to be in the 60% portfolio, and it’s going to drop 26% Theoretically, 1931 It’d be awful nice to have a fair amount of money sitting there and, you know, money markets and short term bonds and different, you know, vehicles that are very safe, so that you could live off of that for a while and let your portfolio recover and come back. Sure. Let’s, in my opinion, that would help me tremendously to kind of deal with those downturns is to have that structure. You know, it’s when you’re really pushing the envelope but everything’s out there and, you know, you’re you’re needing every ounce of Return and then it disappears. That’s when things can get really kind of scary. But having that luxurious setup throughout your retirement, I think is important. And to me, having good emergency monies established, allows people to maybe take a little bit more risk than they would have. So maybe they’re in the 60% portfolio instead of 40, which creates a higher rate of return. By having that money sitting in accounts that aren’t doing that well. And I get that a lot, oh, I’m not making any money in the bank, I’m not making it, it’s not important because that bank money is there to help you have more calmness about those stock market returns, which can be volatile. So really fascinating subject as a whole, you know, I really find that interesting. And so in, in the nutshell, here, essentially, how much risk you could take has to do with you know, what you need to take, but more importantly, what risk you can afford to take. And we have found that really kind of identifying historical downturns, putting that into dollar amounts for the clients, and being able to take a look at that and say, hey, here, here’s what you would lose, theoretically, in these different situations. How comfortable are you with that, and we just kind of find that middle ground. That works. And but it’s an ongoing thing, right? Because I mean, somebody who has a great job, lots of cash flow, all of a sudden, doesn’t have a job, that can change their feeling of risk, right. And so maybe you adjust a portfolio for that, or different situations that might happen in retirement, there are scenarios that happen, that make people shift their risk, because of what just kind of a shock to the financial system, so to speak. So there are some things that happen. So it’s not a constant does change. But it is important. We feel like this is a super important area if you’re in the wrong portfolio, right? If you’re in a more aggressive portfolio than you can handle, you’re gonna lose money. Yeah. I mean, that’s what’s going to happen, because eventually the market is going to fall, and it’s going to exceed your tolerance. And that’s when you’re going to panic and you’re going to sell at that low point. And you shouldn’t have been in that in the first place is what happens in hindsight. So trying to figure out what that is. And it doesn’t help us as advisors either to have you in the wrong place. You know, I don’t really care if you’re 20% or 100%. I don’t I don’t care. I want to make sure you’re comfortable with that as far as that goes.