Basic Investing: Risk Alignment

When it comes to long term investing, a common wisdom holds that income investing is for your old age when you need to reduce risk.  To some degree this makes sense.  The thought is that people who are entering retirement need stability in their investments because they require their income and their assets to be predictable and stable.  Even if a market crash can recover within ten years, if you need to sell those stocks to pay rent next month, you don’t have ten years to wait!  Meanwhile, younger people are recommended to invest in stocks that appreciate quickly because they have the time to wait for a recovery should there be a market crash.  Again, this makes sense to some degree as well.  However, while a useful concept, stereotypical advice fails to account for individual needs and context.  If that young person is having a baby, sending kids to college, or in a divorce, they also don’t have ten years to wait for a recovery to pay their expenses next month.  If that older person has a high appetite for risk or has their basic income taken care of, why shouldn’t they continue to invest in riskier investments?

Investing is an individual action.  Circumstances play a role in when you need your money and confidence plays an equally huge role in how well you can sleep with a given level of risk.  Choosing to use a financial advisor or wealth management company can be useful for people who lack confidence or simply choose not to learn how to invest.  Yet, even those people who select that course need to be aware of the basics so that they do not get talked into riskier investments than they can stand – or to avoid getting scammed by the next Bernie Madoff.  Everyone needs to decide for themselves about their individual context.  

An excellent example of context can be found within Tim Ferriss’ interview of Ramit Sethi (Episode 371) as they cover Sethi’s book, the second edition of I Will Teach You To Be Rich.  While I haven’t read the book, I did enjoy the interview and I have put it on my list of books to read (unfortunately, it is currently a very long list… but I digress).  As for the example, it involved a situation that everyone faces – where do you live and who owns it?  Ramit Sethi rents in New York City even though he can afford to buy.  For him, purchasing a home locks him into one location and he feels like he cannot be assured that he will still be in New York in five years.  Renting provides him with flexibility, removes the hassles and expense of repairs and allows him to devote more resources to investing.  Tim Ferriss bought his home and paid off the mortgage.  For Tim, the emotional security of fully owning the home exceeded the possible value of maintaining a loan and using the freed-up cash to invest growing his net worth.   His peace of mind was the most valuable asset.  They mutually agreed that each of them chose the scenario that was best for them and both were the correct decisions – even though they were the opposite decisions! 

I summarize this part of their conversation as:

• Know the Basics
• Know yourself
• Test your assumptions and know when the ‘rules’ might not fit you

Knowing the basics requires a foundation in the fundamentals, so if you need a refresher on growth, income or risk, see my previous blogs Basic Investing: Growth and Income Investments Defined or Basic Investing: Risk and Return.  To those fundamentals, we also need to add several additional concepts:

Opportunity Costs – These costs are the difference between what you did invest in versus what you could have invested in.  For example, if you choose to buy a house, then the down payment money can no longer be invested in Amazon stock.

Mental Security – Is your investment strategy keeping you up at night?  Are you worried you can lose too much?  Are you worried you are not making enough?  If the answer is yes, you probably need to adjust your investment strategy.

As for knowing yourself, it can be harder than it looks.  I know people who claim they can handle stock risks but lose sleep over their investments’ slightest drop in price.  This is where testing assumptions come in.  If you are losing sleep or losing money on your investments regularly, maybe try a lower risk investment like a mutual fund.  If you are comfortable but want higher returns, explore small investments in riskier asset classes to see if you can handle the risk.  If it turns out you can handle any risk without worrying, perhaps see a psychologist.

In any case, once you have a handle on your risk appetite, you need to pick an investment. I prefer to start small and experiment; later I sell some and buy others. Others want to just buy and forget about it. Either way is fine. Just remember, once you buy one, you might just tie up your funds and be unable to buy another stock. For example, in 2005, I purchased 200 shares of a French pharmaceutical company for $2,500 because it had this cool technology for time-released micro dosing. I could have bought 50+ shares of Amazon at $45 a share, but I wanted to buy even 100 lots… As you can guess, when I finally pulled the plug on my Flamel investment in 2014 and sold it all for $2,000 (loss of $500) I was sad. When I think of the fact that 50 shares of Amazon in 2014 would have been worth $350 a share and my $2,500 would have been worth $17,500 I want to cry! But that is life. You don’t always pick the winners and if you have picked a loser, your money is tied up in that opportunity cost until you dump it.

Here are three scenarios to illustrate broadly generalized personality types and their recommended investments:

Example 1: Risk adverse
Miss A hates risk, she can’t stand the idea of losing money.  She also is not sure if she’s going to be able to stay in the US to work or if she will need to move back to Japan to take care of her parents.  With the uncertainty, she needs to rent for her housing.  While that theoretically makes more money available for investments, since she hates the idea of losing money, stocks are too volatile for her to be able to sleep at night and she doesn’t have the confidence to pick bonds.  Therefore, she keeps the bulk of her money in certificates of deposit at the bank (guaranteed return) with her ‘high risk’ portfolio invested in a target date mutual fund (with a mix of growth and income investments).   

Example 2: Some risk OK, but it can’t drop much.
Mr. B also hates risk, but he values security, stability, and a reasonable return.  He also has retired, so his priorities are to preserve what he has and to provide income for living.  In the past Mr. B has invested in stocks and even options for growth, but now he focuses on US Treasury bonds.  While US Treasuries are not risk free and can decline in value, their risk of failure is very low.  Mr. B likes to say that if the US government fails to honor their obligations then it won’t matter – any other investment will have gone to hell already anyway.  Treasury bonds do go up and down in value, so when investing, Mr. B attempts to purchase bonds below their face value (EX: buy a $1,000 bond for $958) so he can obtain a higher yield than just the coupon (official interest rate).  After many years of studying the bond market, he generally can anticipate how the interest rates will move and tends to wind up with a large number of bonds when interest rates drop and the value of his bonds will surge.  In fact, Mr. B has been known to achieve returns of over 10% on a regular basis!  He has found that ‘safe’ income investments can yield high returns if you learn how to invest in them well, it just takes work.

Example 3: Risk is fine. If it drops, it will come back.
Mr. C has many years before he can afford to retire, so he values growth of my assets more than he values income or stability.  Mr. C invests in mutual funds, index funds and stocks because his money is in primarily in retirement accounts he cannot touch for decades.  Mr. C is basically me, so let me add some personal details.  I like stocks.  I am opportunistic about my purchases and I get lucky sometimes.  Sometimes, I get unlucky.  Since I know I am fallible, I invest conservatively because I don’t have that much money to lose!  My method to reduce risk is to diversify and not put too many eggs in one basket.  To me, bonds are $1,000 stocks with a questionable commission system, so I am leery about investing them without the capital and experience of Mr. B.  Instead, I purchase mutual funds so I don’t have to be the expert and I can invest smaller amounts.  My son is also going off to college, so I need to have a significant chunk of my funds stable and easily available to pay his tuition over the next few years.  Thus, I have purchased the USAA Income Fund to obtain a decent return (~3%) and preserve his tuition fund.  I still invest in stocks in my retirement accounts and take advantage of the tax free growth.  I like to have a mix of dividend paying stocks, well known corporations, mutual funds and a few speculative investments.  I have a much larger appetite for risk than the other two examples.  For me, my low risk stocks are my favorite companies that have been a solid investment for decades such as 3M, Intel, and Corning.  They don’t always grow the most aggressively, but I am very confident that these companies can (and have!) weather a harsh economic environment.  

Three very different profiles lead to three very different investment strategies – each suited for the investor.  As you can imagine, with increasing risk comes the potential for increasing returns.  As long as you recognize your own appetite for risk accurately, there will be no internal conflict and sleepless nights.