Several years ago, a partner and I sat in a conference room at a mutual fund company down south with 40-50 other top-level advisors. The main keynote speaker for this entire conference was Eugene Fama, a Pulitzer Prize-winning Laureate of Economics.
Mr. Fama spoke to us about his history and the countless hours of research he did over decades on the stock market. At the end of his presentation, he opened the floor for questions from the audience. To my shock, it became a “chest-puffing” match in the form of questions challenging the ideas of one of the brightest minds in our industry. Mr. Fama never changed his tone, never became frustrated, and answered every question calmly and attentively. I knew at that moment “wisdom” is silent; it does not raise its voice or get loud. It accepts challenges because in the end it knows and is certain. It was at that moment, a young kid in the front with an old dusty suit stood up and asked Mr. Fama, “If you were on our side of the business and knew what you know about the markets, what would you say is the most important part of our job for our clients?” Mr. Fama looked up with a big smile on his face and said, “RISK!!!!” “It is your job as advisors to help each of your clients clearly identify their taste and tolerances for RISK in their investments.”
This got me thinking deeply. When it comes to investing, what is “RISK”? RISK can be defined by the opportunity to gain significant money at the RISK of losing significant money. For most people RISK is defined by feelings. “I lost a lot of money in 2008 so I don’t like RISK!” or “My parents lost everything during the last recession when I was a kid, so I hoard my money!” Those things are relevant but can get you in trouble if that is all you are basing your decision on. The real question that should define RISK is “exactly what are you trying to accomplish?” Simply “Making money” is not an objective, you need to be more specific. How do you quantify “making money”? If you make a nickel a day, you are “making money,” but is that your objective? Making $8,000 a month or $30,000 a year makes the objective more quantifiable and more achievable. When it comes to RISK, I find many don’t factor in their goals and objectives.
I will give you an example: let’s say you have $300,000 when you retire. You sit down to come up with a plan and realize you need $45,000 a year for the next 10 years. I ask you what your tolerance is to RISK, and you say, “I hate RISK!” Well, one of two things are going to have to happen. Either you are going to have to take far less than $45,000 a year, OR you are going to have to add stock RISK to the investment to get the earnings you need to create that payout. The point in all of this is your RISK exposure should be in line with your goals and objectives.
With all the huge opportunities many specific individual stocks have given us these past 10 years it has never been more important to understand RISK clearly. From Amazon, Netflix, Google/Alphabet, and Tesla to cryptocurrencies and many more, the stock market has become a proverbial main floor of a casino on a Saturday night, and no one can lose. It was the godfather of physics, Sir Isaac Newton, that once said, “What goes up must come down.” As I write this, I am not suggesting a looming correction or recession. What I am saying is the markets are cyclical - they go up and down. We unfortunately just don’t know when they will go up or go down. Therefore, it is so important to have a clear understanding of RISK for you and your specific goal.
In conclusion, now is the time to analyze RISK within your investments. Do it regularly, especially when it comes to individual company stocks. If your goal is making ten million dollars or having $100,000 a year in income you cannot outlive, does it make sense to do so in 3 or 4 top-notch stocks? Or does it make sense to preserve some of those large earnings many have experienced and do so in a more calculated way based on RISK/OBJECTIVE? The problem is when you do not understand and analyze RISK regularly, and when your objective is “making a ton of money”, you can fall into the trap of the downside to the RISK that got you the reward in the first place.
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Written by Ronnie Thompson