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WHICH FINANCIAL dangers should we focus on? The possibilities seem pretty much endless. In fact, five years ago, I decided to make a list—and ended up offering readers 50 shades of risk.
Yet our notion of risk used to be far more circumscribed.
In the late 1980s, when I started writing about personal finance, insurance was considered important, but it wasn’t much discussed. Instead, the only risk that seemed to merit serious analysis was investment risk, and that could supposedly be captured by a single, objective measure: volatility.
This approach had intellectual appeal. By focusing on volatility, experts could sidestep a thorny issue—the fact that some investors were totally freaked out by investment price swings, while others remained unperturbed.
Part Four of Six
As data on historical market returns became more readily available, talk of short-term volatility was joined by discussion of longer-term risk. How likely was an investment to make money over one, five, 10 and 20 years? Once again, it was all about the numbers, with investors themselves strangely absent from the conversation.
The good news: Today’s discussions of risk are more nuanced, reflecting an awareness that the danger from misfortune is matched by the damage that can be done by our own behavior. Consider the typical stock-market cycle. Thanks to research by behavioral-finance experts, we now have a pretty good idea of how investors’ thinking changes along with the market.
What goes up. The goal of investing may be to buy low and sell high. But at market bottoms, when stocks might be available at 30% or 40% below their bull-market peak, we’re often frozen in place, fearful our own actions will make matters worse. Sins of commission and sins of omission can both cause financial pain, but sins of commission are much more likely to trigger pangs of regret.
As share prices tick higher, some of us will look to sell, as we recoup part or all of our losses. We’re anchored to the price we paid for our investments or to our portfolio’s highest value, and we’re anxious to sell before recent gains turn to losses once again. It’s the old “get even, then get out” syndrome.
Others, meanwhile, take the market’s short-term gain and extrapolate it into the future, prompting them to invest even more in stocks. Like the soothsayers of old, we study the market’s entrails, trying to divine the future by spotting patterns in today’s share-price movements. Our portfolio’s rising value makes us more confident not only about the rally, but also about our own investment acumen, as we attribute our gains to our own brilliance.
Among some investors, the rising market may even trigger the so-called house-money effect. What’s that? Like casino gamblers who get lucky early in the evening, bull markets can make us feel like we’re ahead of the game, prompting us to trade more and take additional risk.
What do we buy? Often, we’re drawn to the familiar, such as our employer’s shares or companies whose products we use. Alternatively, we might flock to soaring stocks and funds that are in the news or that others are currently raving about.
Taken together, such investments may leave us with a badly diversified portfolio, and yet familiarity and popularity can make these stocks feel like a safe bet. Buoyed by the enthusiasm of others, we end up with a far more aggressive portfolio than we owned at the bull market’s inception—setting us up for hefty losses when stocks turn lower.
All fall down. As share prices slide, we shrug off the setback, ignoring negative news and the market’s rich valuations. Instead, we seek validation in the words of Wall Street’s bullish pundits, taking courage from their upbeat market assessment.
But then stocks’ losses deepen, the pundits grow more equivocal and our confidence ebbs away. Initially, we’d expected the decline to reverse. Now, we start extrapolating the losses, wondering how much worse things will get.
At the market’s peak, we would boast to others about our high tolerance for risk and our hefty allocation to stocks. But that bravado evaporates along with our portfolio’s gains, and now we wish we owned a far less aggressive portfolio.
Enter loss aversion—our tendency to get far more pain from losses than pleasure from gains. Stung by our portfolio’s decline, some of us sell in a panic, because our investments are now underwater and we imagine things will get far worse. Alternatively, we might “double down” on our stocks, with an eye to speeding our portfolio’s recovery should the market rally.
But most of us simply sit tight. During the bull market, we took great pride in selling our winners, even if the result was hefty capital-gains taxes. But now that tax losses are readily available, we’re loath to take advantage, because we hate the idea of selling for less than we paid. Instead, we comfort ourselves by saying “they’re only paper losses.”
What about buying? Everything tells us not to: The news is relentlessly bad, the pundits declare that the bear-market bottom could be months away, and the market’s decline makes further losses seem inevitable. Stocks may be on sale, our wise neighbor declares that this is a great opportunity and we might even agree—but buying simply seems too risky.
Check out the three earlier articles in this six-part series: Money Grows up, Taking Center Stage and Mind Over Money.
Jonathan Clements is the founder and editor of HumbleDollar. Follow him on X @ClementsMoney and on Facebook, and check out his earlier articles.
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My 2 cents. First and foremost, no one can predict the future. We do know there is another bear market on the horizon; we simply don’t know when. With that knowledge I’ve decided it is more important to position my portfolio for that inevitable bear, rather than worrying about it or attempting to avoid it. I will participate in it, that is guaranteed. I do hold some cash, which reduces my returns. However, I can deploy at opportune times and yes, I do realize I’ll never time the market and deploy at the bottom.
There are compromises to be made.
Education helps to manage the emotions. When I was a young draftsman the firm that employed me had many individuals who invested. During one nasty bear market, I recall a discussion the substance of which was “It doesn’t matter what I buy, it all goes down.” I concluded that investing was gambling, and with little knowledge it certainly would be for me.
As time went on, I became aware of mutual funds and later ETFs. I became aware of diversification and stock allocation and index investing. I also became aware that over long periods of time the S&P showed gains and dividends were desireable.
I also became aware of simple tools for portfolio analysis, such as the Morningstar X-Ray tool and Firecalc.com.
However, some bear markets are worse than others and it is dangerous for one’s financial health to invest in vaporware. At one point during the Dot-Com bust, my retirement portfolio had been reduced to about $8,600 with permanent losses.
Time, it has been said can heal wounds and so it is with my investments. I took what I learned and weathered the 2007-8 banking fiasco. Because I’m a net saver, I had funds to invest carefully and I did. I also invested in individual stocks because that is a way to exceed the returns of the S&P 500. However, the ballast for my little sailing ship was, and remains mutual funds and/or index ETFs with a sprinkling of sector funds. Overall, my portfolio is comprised of about 27 holdings and because I’m retired is largely on autopilot.
As for time, it does matter. A bear may last for 5 years and so too for a boom. An investment horizon of 20+ years worked for me, and I buy with the intention of holding it for at least 5-10 years. Many of my current holdings were acquired 17 years ago.
Back in the 08-09 financial crisis, every bone in my body told me to sell and I got more pain after they fell further after my October 2008 rebalance. I darn well may have panicked but Jonathan Clements talked me off the ledge.
We are born “broke”, we were just short of broke 43 years ago when we got married, we were told that we’d never be fully ready (financially or otherwise) for having a child and that remained true right through to child number four. Several major health issues for family members including watching my wife flatline several times post-op, in a room full of doctors and nurses, and then struggle to remain alive for days until they figured out what was wrong. Icing on the cake – my *#+%!@ boss called to tell me to come back to work because, “I wasn’t a doctor”. Four young children at home that we had just moved into. Happened again 1,000 miles from “home” just a year or so later. Miraculously, several cars totaled by young drivers that walked away with barely a scratch (even the responding police officers were amazed). The list, unfortunately, goes on. What contest in hell did we win?
Lucky? Yes, both good and bad.
Blessed? Truly and without question.
Still standing? Heck yes. Hinges are a bit rusty and the frame is bowed a bit, but OK.
Family fortune? No, but fortunate to have a great family.
Reading the excellent ‘50 shades” list, what comes to mind is, if you ever think you have it made, best think again. You can never be prepared for all of what could come your way, including financially. Best make today a great day.
I went back and read “50 Shades of Risk.” Don’t know how I missed that but what a great article.
A very human reaction to risk is this: Oh, that won’t happen to me! And yet, of course it can, and sometimes does. I’ll admit I do this all the time until I force the question to deeper consideration.
Here’s an interesting exercise. Go through Jonathan’s 50 Shades of Risk list and tick off those you’ve already experienced. Then do another pass and circle the ones which have happened to friends or family. What’s left? Only the funny ones.
🤦🏻♂️😩I hope Not!
I’ve done well in the market by sheer dumb blind luck. I would have done great if I had had the ability to listen and follow someone like Johnathan early and often. I thought too much of my own opinion and acted accordingly to my later regret.
The only no-brainer to me is the initial decision to invest vs holding cash. Since the value of a dollar declines almost without interruption, one first needs the supposedly “risky” path of choosing an alternative the offers a better outcome. Stocks are that path. Timing and choices certainly affect one’s portfolio performance, but there seems to be a lot more risk in holding cash over long periods of time. That iceberg is constantly melting. It is still a better option to stand on another iceberg – as long as it melts more slowly.
Since we went off the gold standard, so to speak, in 1971, the $ has been debased at about 7 to 8 percent annually. At a minimum, that’s our hurdle rate if we don’t want to fall behind. It’s more than inflation as measured by the CPI. So yes, an iceberg in a very cold climate would be better.
In my early days as an investor and before I owned a computer I was constantly extrapolating my future wealth with my little HP12c financial calculator. Then life struck a blow in the form divorce and bear markets. I used to try to guess the highs and lows and eventually realized that I don’t guess well. These days I fall into the don’t sweat the small stuff category; it’s all small stuff.
In late February or early March of 2009, I remember my brother calling me and saying, “Have you sold anything?” I said, “Nope.” He said, “Me neither.” It was a pretty dark time as I’m sure many of us remember, but like always, when the market went way down, I did nothing because I didn’t need those investments for anything right away. One of my boys started college in 2011 and his Coverdell ESA took a big hit, but it started to come back and he saved the day with a great scholarship leaving him with excess college funds he later used for medical school. Like Jonathan says, I’ll take a sin of omission over one of commission any day.
I wish we would have had more money to buy in early 2009, but we had kids in college too. The small positions we did buy then have been our best investments. Chris
I was too chicken to put in more money other than my monthly dollar cost averaging into IRAs and college funds for my 4 kids.
I know several people who bailed in March of 2009. Not only due to the financial calamity but also because of the new president. Neither reason, it turned out, were good criteria for selling.
Yup, a hard lesson learned. I sold a chunk of V, wish I had it back.
“The goal of investing may be to buy low and sell high. But at market bottoms, when stocks might be available at 30% or 40% below their bull-market peak, we’re often frozen in place, fearful our own actions will make matters worse.”
I have kept a list entitled COVID Buy and Sells since 2020. I had inherited a fair amount of cash in December of 2018, but didn’t invest it at that time as to quote Alan Greenspan I felt the market was too “frothy”. During the COVID drop I quickly devised a plan and decided to follow the closing level of US and international market indexes (we all had a lot of free time on our hands). I decided to first buy when the market hit correction level, again when it hit bear level, and the every 5% drop after that. Then sold all shares when the markets returned to the correction level, and then bought bonds to get to my proper portfolio allocations.
All that work netted me a 7% additional return. Could I have made significantly more if I had continued to let the stock purchases ride? Absolutely, but I decided to stick with a my plan and not get greedy by waiting until the market returned to its prior peak as I had no idea how long that would take.
One issue to consider in deciding whether volatility is a good measure of risk seems to depend on whether you are persuaded there is mean reversion. The data series is too short to know the answer to that – in the past the US has exhibited mean reversion while some foreign markets havent.
Good article Jonathan. I distinctly remember the feelings of “get even, then get out” with several of my early investments. Those experiences convinced me that I have no real ability to pick individual stocks, and that I should stick to inexpensive index funds.
Thoughtful article, as always, Jonathan.
What’s uppermost in my mind is the risk I’m taking on. When your money is in stocks it’s always at risk. That’s difficult to remember in a bull market—but age is also a consideration.
Tilting our portfolio toward more conservative investment, in retirement, has been the best choice for me. Instead of thinking how much money we could be making, I bear in mind how much we could be losing.
What’s more difficult: investing rationally, or admitting that we don’t?