Dallin Blogs

Do you understand the RISK you take when you invest?

Written by Dallin Cutler | May 24, 2024 11:53:02 PM

Setting proper expectations is a good thing. Understanding the risk you take when you invest is an exercise in setting proper expectations. This seems like a healthy thing to do... so I made a video about it.

 

What is risk?

Here is the dictionary definition: a situation involving exposure to danger.

That makes sense... but that seems more applicable if I jumped into a Lion Exhibit at the Zoo.

What does RISK mean when you are investing?

Could you temporarily or permanently lose some of your money? What about all of your money? Might you go an extended period of time with lower than expected returns? Will you underperform in bull markets and outperform in bear markets? Perhaps vice versa? What is the likelihood of your strategy working over one year? What about over five years? Twenty years? What does it look like if it doesn't work? How bad might you underperform? What RETURN should you expect? What if expectations are not met?

Do you know the answers to all these questions?

If you have no idea, you have no idea the risk you take. If you don't understand the risk you take, you will make poor decisions when "the risk you take" rears its ugly head.

Let's understand the risk you take
Traditional Risk

The backward looking metrics that set future expectations.

  • Volatility: What has been the spread of outcomes/returns previously? If the spread is large, the expected volatility is more. If the spread is small, the expected volatility is less. (Show portfolio slide with different portfolio spreads)

  • Max Drawdown: How far did a particular investment fall from peak to trough? How much should you anticipate (and prepare to stomach) during a bear market or if your investment asset turns south for a period of time? (Use Kwanti and show peak to trough in real estate)

  • Correlation: How "correlated" is your investment to the "general" market. This one can be a bit confusing for unintelligent people.... like me. Here are two examples to help... people like me:

    1. You own an S&P 500 Index Fund = High correlation to the S&P 500 Index (the price of each will move like two well practiced synchronized swimmers)

      You own a single stock within the S&P 500 Index = Partial correlation to the S&P 500 Index (the price of each will move like two novice synchronized swimmers)

      You own a single small cap stock = Low correlation to the S&P 500 Index (the price of each will move like two toddlers swimming in a pool)

      You own a Baby Grand Piano = No correlation to the S&P 500 Index (the price of each will move like two fish swimming in two different oceans)

    2. You own a 2020 Ford Explorer = High correlation to the 2020 Ford Explorer used car market

      You own a 2010 Ford Explorer = Partial correlation to the 2020 Ford Explorer used car market

      You own a Tesla = Low correlation to the 2020 Ford Explorer used car market

      You own a collection of cat sweaters = No correlation and don't tell people.

 

Understanding "Traditional Risk" is important BECAUSE setting proper expectations is vital.

Active Risk

The current investment decisions you make.

  • Waiting for the market to drop before investing (opportunity cost risk)

  • Investing all your money at the top of the market (bad timing risk)

  • Chasing investment returns (Not understanding investing risk)(Not understanding risk risk)(Being impatient risk)(Being greedy risk) see video for example here

 

I am making these different types of risk up, if you couldn't tell. Actions have consequences, that is really all I am trying to get across here. With investing, sometimes, people don't understand the consequences (and risk they take) with the current decisions they are making.

Guess what helps mitigating "active risk"? Understanding "traditional risk".

ROLLING WITH THE PUNCHES

Mike Tyson once said "everyone has a plan until they are punched in the mouth".

I am sure every boxer went into a fight with Mike Tyson with a game plan... and then he punched them. What did they turn to after that (if they didn't get knocked out)? Likely, their most primal defensive and offensive instincts. The fight or flight instinct in all of us.

What do you think your primal instincts will be when your investments inevitably punch you in the mouth?

The best training is knowing the risk you take and being okay if it actually happens.

Here's a training exercise (video above does this for you):

  1. Go look at the S&P 500 Index performance from 2000 to 2010, and then compare to it's performance from 2010 to 2020. What happened? Know the risk you take if you concentrate your investment too much into one asset class.

  2. Go look at the comparison between the stock market and cash over the last two years (2022 and 2023). Then go look at it since the beginning of this century until now. All about setting proper expectations and knowing the risk you take!

Now you are trained. Go forth, be brave and revisit this video every couple of months.

Sources & Disclosures found in the video link on Youtube