Risk: Challenge the Dogma
Every financial advisor has a diagram explaining risk to potential clients. The diagram is a scale or matrix listing the risk level of each investment product.
Investments in the “low risk” category are fixed income products with a risk of 1 out of 5. The “high risk” end contains baskets of stocks typically in the form of mutual funds which have a risk of 5 out of 5.
This week, I have decided to grace you all, not only with writings that rival George Orwell, but magnificent creations only second to the Dutch Golden Age painter Rembrandt himself. I have spent hours studying the dynamic lighting in The Night Watch and feel my creations, despite not being 12 feet wide, deserve a seat at the table of greatness.
I know many who invest in the “low risk” category their entire lives because they don’t want to lose money. It is a nearly 100% safe bet to not lose money. The only potential for not receiving the interest is the United States government no longer exists. We then have bigger problems than collecting EE series bonds.
There are significant problems with this mindset that I will attempt to explain shortly. Risk goes beyond what one may lose.
I have so many problems with the method financial advisors use to explain investment risk to potential clients. This begins with the interpretation of risk.
Risk Reward Matrix
I challenge each of you to think about risk in multiple dimensions, not only for personal finance, but everything you do. Or don’t do.
Every action has potential upside and downside. Compare the potential gain to the potential loss to best determine whether this action is best done or best left undone.
The upside Y-Axis is the size of the reward. The downside X-Axis is the degree of unpleasantries.
For the sake of commonality, let’s analyze becoming a CRNA.
The upside potential is solidly “A tier.” A fulfilling and essential career currently in high demand. Financial compensation is upper-middle class anywhere in the nation in any setting. The work is hands-on, but not overly difficult on the body.
The downside potential is notable. A major drawback is opportunity cost which includes the years of training and significant monetary costs. The academic horsepower needed for CRNA school may not be for everyone.
At the end of the day, for anyone considering specialty training or a terminal degree, there isn’t really a better monetary option than anesthesia due to the compensation compared to opportunity cost. The content and study hours are intense, but doable. All in all, the downsides are like having your foot run over by a bicycle. Painful for a short while, but worth it for the prize.
For those not suited to the academic setting, the downside potentials are more potent simply because books aren’t their thing. And that’s okay. Reading textbooks would be maximally unpleasant, similar to getting hit by a train. And that’s not okay. So yes, the matrix is different for everyone.
Allow your eyes to feast on yet another diagram providing an anesthesia specific example of a risk reward matrix.
Regional anesthesia...so strong. It makes for a simple and safe anesthetic. With the use of ultrasound, complications are infrequent making this a strong option.
Emergent cases are theoretically life or limb. This means the overall risks, not necessarily anesthesia risks, have more upside than downside potential. But nonoptimized patients carry a laundry list of potential downside events.
Knowing someone is likely to have complications with a certain technique means that is likely a poor technique. Maybe that’s a sedation case on a full stomach. Perhaps poking an anticoagulated patient. You get it. Avoid the stuff that’s guaranteed to go wrong. Your attorney will thank you.
Let’s apply the risk reward matrix to personal finance theory.
If I maintain a reasonable cost of living, I will be able to save money and eventually retire. If I spend all of my income on experiences and possessions, I will have a fulfilling, adventurous life. Both thoughts are likely true.
Both situations manifest from calculated spending. Aside from where money is spent, what's the difference? Risk.
If we spend all of our income in the present to enhance today, there will not be anything for tomorrow. Similarly, if we put everything away for a day to come, we may never see that day -- never enjoy that money.
There isn't a right or wrong answer in this example. Consider both sides of the flapjack and live somewhere in the middle.
I use this example of saving vs spending because it’s one I struggle with. I’m all about delaying gratification and saving for the future. Not only for my future, but for my family’s future.
Compounding interest is maximized through time, so the earlier I can invest significant cash, the more time my earnings with have to grow. Plant the money tree early. Financial security is pretty high on my Y-Axis. I want to be covered if something unexpected happens.
My X-Axis is made up by the time spent at work and the money I don’t enjoy in the present. I’m a workaholic. I find purpose in what I do and actually look forward to Mondays. In future years, this will affect time with Mrs. TFC, aging parents, siblings, and potential children.
I’m not a big material possession guy, so that’s not an issue. Experiences are something I go for, so that’s notable.
How I handle it.
Full disclosure, my life is a constantly adjusted “work in progress.” I currently work a fair bit. Mrs. TFC and I save around 75% of our net income. Not too shabby. This is rewarding and we watch our net worth grow monthly. Quite rewarding.
The time aspect is my greatest downside. I go for quality time, not quantity time. If I am just sitting on the couch mindlessly scrolling social media, I could be making better use of my time. So, I do just that, make use of my time away from work.
Monetarily, I spend money in select areas that are important to me. Fortunately, none are big ticket arenas. We spend money on overpriced travel to meet with friends and family. It’s overpriced because time away from work is limited, so we are stuck with whatever flight or hotel is available.
And we splurge on dining out mostly to experience new cuisines. Or things we don’t make at home. I said no to odorous curries and filo pastry dough. Love them both, but I won’t make either at home.
It’s likely the 50-year-old me will wish I spent more time doing XYZ, but who knows. Peace of mind and financial independence is worth a lot, so I’m happy with my choices at the moment. Only after I’m six feet under will I know the answer to this dilemma.
Let's circle back to an investing concept mentioned earlier.
One could invest in conservative fixed income products such as bonds or CD's. This produces guaranteed income. Over the past decade, the return on these investments has been horrid. Far South of 1% annually. One could argue the thought is wealth conservation.
What's the risk? Losing buying power. Inflation and rising costs limit the value of a dollar.
Think about how much your parents paid for their house. In the early 1990s, my parents paid $60,000 for their current residence.
My grandparents purchased a similar home (likely in the early 1970s) just two streets over for $14,000. That shows the generalization that a dollar today is more valuable than a dollar tomorrow.
Appreciation and equity are two strong arguments for real estate as an investment. I could ramble at length about how it’s important to know the numbers and an area prior to making a purchase as an investment. Money is made or lost on the buy, so study up.
Real estate investors typically put in more hours than those investing in the market, which is why I recommend folks get squared away with their personal finances before dipping their toes into the real estate pool.
Because unlike bonds, the real estate market fluctuates. Look at home buyers from 2007. Things break. Vacancies happen. There are mortgages, taxes, and insurance that need to be paid whether there is a tenant or not.
The potential downside is greater, but the potential upside is exponentially greater than bonds.
Stock market investments work the same way. There is absolutely a chance that you will lose everything. That your stocks will be worth less than the paper printout that shows you own them.
It’s easier to accept a calculated investment with increased downside risk if you have your personal finance house in order such as an emergency fund, debts paid, adequate insurance, and consistent CRNA income. So, what if an investment doesn’t work out? You still have a roof over your head and food on the table. Analyze an unsuccessful investment and make alterations for the future.
If you can accept the significant downside risks for stocks and real estate, consider investing in these avenues for the potential exponential upside.
I wish professional financial advisors would say “low risk” means you won’t lose any of the principle, but you will lose buying power over time due to inflation.
And “high risk” means a diversified index or mutual fund that tracks the market. This means you will have significant volatility -- ebbs and flows -- but over a lifetime, it’s very likely that your investment will not only outpace the market but be great enough to increase buying power and support your retirement.
They should then use appropriate asset allocation to give the portfolio just the right shape based on the age of the client.
True “high risk” investments are unproven investments such as venture capital and newfound cryptocurrencies. All of us had, and still have, the ability to buy millions of shares of many crypto currencies for a mere $10,000. If the shares increase in value to even 10 cents, that initial investment would be worth 8-figures.
Or if the coin flops, we are out $10k. There were years to buy $300 bitcoin. There were then 2 opportunities to sell for $60,000 per coin. That would have turned $10,000 into $2M. For all of us that figured, “too much downside risk”, we lost out on that 200x return in 5 years.
What about a $50k investment in the early days? Or $500,000? Another example of the risk we run by investing AND not investing.
That’s just my 2 cents. I’m not about to change how financial advisors speak to their clients with a single blog entry, so I won’t drone on any longer. I challenge each of you to apply the risk reward matrix to your own portfolios and financial decision making to see if anything changes.
