How to take a smarter approach to managing risk with your investments
Even if you haven’t seen the movie Dirty Harry, you’ve probably seen the clip where Clint Eastwood’s character Harry Callahan has his gun pointed at the bad guy lying on the ground while he calmly describes the magnitude of what would happen to him if he pulled the trigger. Then he tells him “You gotta ask yourself one question: Do I feel lucky?”
And that’s a question I’ll ask you, because when the financial markets are going up, it’s easy to forget about how much risk you’re taking to get those returns on your money. I mean who wants ever think that a winning streak is going to end, right? But, as you know and as the market reminds us every now and again, trees don’t grow to the sky and what goes up must come down – even, if in the stock market’s case, it usually does go back up again later.
The motivations behind most people’s financial decisions can be traced back to two main influences, even if they don’t like to admit it. And that’s fear and greed. But as the Nobel Prize winner Richard Thaler found in his study of behavioral economics, we don’t always make rational decisions based on facts. Imagine that, right? Our emotions get in the way of making smart decisions. And I’ve found that fear is a much more powerful emotion than greed when things are not going so well and your accounts are dropping just as fast as they rose just a few months earlier.
So basically, it isn’t that we’re all so dumb when it comes to money. It’s more the case that the world is just hard. We’re constantly trying to gauge where we are in relation to where we’re trying to go and then make wise decisions that serve our interest in the safest, most efficient manner possible. But we get in our own way sometimes and that sets us back more often than any of us would like to acknowledge.
What if? To improve our results in a lot of our decisions, it’s helpful to take the other side of the argument too, especially when it comes to making financial decisions. What if the movie that plays in our heads when we are evaluating our next financial move DOESN’T have as happy of an ending as we imagine? How much can we stand to lose before we’re in real trouble? And what risks are we willing to take or avoid in exchange for that possibility.
Thinking through these questions and others related to financial loss will help you determine your risk tolerance. And at first you’ll probably be way off in terms of what your REAL capacity is to absorb losses. Losing 10% of your portfolio in a market downturn doesn’t sound too bad, especially if the market has dropped twice as much or more compared to what yours has. But, when that translates to $70,000 less in your account, it becomes very real – and painful.
Can I get a volunteer from the audience? Think about it like this. You’ve probably seen a magician who asks someone in the audience for a $20 bill. Or maybe it was a $100 bill. Inevitably, the magician does something to destroy the bill and cause the person on stage with him to sweat a little wondering what’s going to happen next to his money. Of course, part of the trick is that the money always comes back together and the natural expectation from the guy in the audience is that he will get his $100 back when it does.
Now this is where the magician acts like the trick is over and that the guy can go back and sit down – while the magician pretends like he is going to keep the money. That’s usually where the most awkward part of the bit kicks in. The audience member doesn’t know if it’s really a joke or not and he’s usually unsure whether to stick it out and get his money back or go back and sit back down without his money like the magician said. Of course, it IS a joke and the guy gets his money back in the end, but what if that guy was you - and you actually didn’t get the money you gave up for the sake of the trick? Would you be disappointed? Would you be upset?
Now that may seem like a ridiculous scenario to put you in, but think about it with me for a minute. Why is it that you feel comfortable losing a percentage of your overall investments, but then worry over losing a much smaller amount of money as a part of the show on a fun night out on the town? Whatever amount you would feel uncomfortable losing in THAT scenario is probably more in line with what your real risk tolerance is. After all, whether you lose it in the market or as a part of a funny bit in a magic show, it’s still a loss, right? So what’s the difference?
The answer is – there is no difference.
And that’s what I want you to think about here because most people are taking way more risk than they need to with their savings. Whether it’s because of greed or just because they’re unaware of what’s really going on with their savings, the average person usually doesn’t realize how much risk is involved in their approach until it’s too late and they’ve lost a fortune with a bad investment or in a market crash. But I’m hoping this article will cause you to look not just at how successful you’ve been, but also at how much risk you’ve been taking to get here.
You don’t have to be a two time loser Like I said in the last article, if you lost money in the market back in 2008, or at any time really, how did that make you feel? More importantly, what are you doing differently now that will prevent it from happening again. After all, market corrections are not surprising events. They’re reoccurring events, just like cold winters are in the North. You have to prepare for them, but do so in a way that doesn’t hold you back when things are easier and more comfortable.
See for most people I talk to their greatest risk is not missing out on the next great run in the stock market. Their greatest risk is losing what they have and then having to suffer through the disappointment and years of waiting for things to come back, if they ever actually do. Most people can’t stand the fear of losing more money when the market is sinking and they throw in the towel when things collapse to a point that breaks their resolve. Then they miss the economic recovery that follows, which delays their own financial recovery even more.
Has that ever happened to you?
In order to properly manage your risk levels, you need to know what you have and what risks you are exposed to within your investment portfolio. Taking an inventory and having it analyzed to see how much risk you have vs. how much you think you have, and even more importantly how much you should have, can be an eye opening and life changing experience.
In my office, we offer a free review that will show you how your investment mix has performed over time and how efficient or inefficient it is with its mix of risk and return. If you’ve never had this done by an independent advisor, you owe it to yourself to do it as soon as possible. People always say they’ve never seen anything like the reports we create, but getting a true diagnosis on how their nest egg is REALLY positioned has helped hundreds lower their risks and improve their results.
The truth will set you free So you may be thinking, I probably don’t need to do this because I’m diversified and my advisor has everything under control. That may be, but let me tell you that one of the biggest enemies to creating a better mix of investments that support your overall financial plan is the emotional connection people have with the conventional wisdom that is so widespread within the financial media and investment advisor community. Many of the things you hear and read sound good, so very few people question their actual validity. But, if all of this conventional wisdom was so effective, why aren’t more people wealthy?
In order to truly take charge of your financial future you have to see where you are today vs. where you really need to be – and then be willing to rethink concepts and strategies to capture more of the upside while reducing your exposure to losses.
I understand that it’s especially tough to make these changes in your mindset if you’ve been successful in the past. But let’s face it - you’re not as young as you used to be. And during the last two major declines in the markets where the averages were essentially cut in half in less than 18 months each time, each recovery took between 4-6 years to get the market all the way back to where it was before the cash.
Do you have the time and resolve to do that again? And even if you do, why does it makes sense to needlessly suffer through that again when there is a better way? I mean at what point will your luck run out and leave you stranded? Do you really want to push it that far?
Now is the time to reconsider your game plan and design a strategy that includes both diversification and allocation of specific percentages in a variety of categories within your savings and investment portfolio. It’s what the wealthy do to build and preserve wealth, and you can jumpstart your path to wealth by having your accounts independently reviewed by one of our seasoned Certified Financial Planner Professionals today. Like Dirty Harry would say, “Go ahead, make my day” – or in this case make your day by simply requesting a complimentary analysis today.
It will be one of the best investments of time you’ve made in a very long time – I promise!