The Boy Who Couldn’t Risk

I prepared this article  as “homework” for a personal finance elective at a college-preparatory high school I might be contributing to in the Fall. Perhaps it would be helpful to parents whose kids are smitten with the Magnificent 7 or crypto.

After a stock market decline, people may perceive more risk than before, when the decline may have taken some of the risk out of the market.

—Robert Shiller

The investor’s chief problem—and even his worst enemy—is himself.

—Benjamin Graham

Patty wants to go to the prom with Danny. But with barely two weeks left before the affair, Peter asks her out. Does Patty accept Peter’s invitation or does she wait for her first choice to come through? Play it safe or go for it.

Steve is struggling with a different kind of dilemma. He knows Samantha would accept a date in a heartbeat, but the prom is the last chance for him to have a date with Maria, the exotic transfer student from Brazil. Does Steve choose his good friend or roll the dice with a secret flame?

You Can’t Escape Risk

 How much risk can you take without becoming a little anxious? Are you a high or low risk-taker? Could you skip much of chapter 5 because the War of 1812 is so-o-o boring? Samantha doesn’t bother to go over her lecture notes for the final because on the midterm old man Hendrickson only tested on the readings. What about Steve? He reviews everything so as not to be blindsided.

Taking risk doesn’t end with becoming a high school senior. Do you apply to more than one safety school or enroll in calculus to compensate for your low math SAT score. Then, it’ll be making a traditional family or not, and charting a safe or more challenging career. Each stage of life comes with its own bundle of risks and associated anxieties. Nobody gets a free pass.

Investment Risk Tolerance

Success in the stock market partly hinges on knowing your risk tolerance and how it influences your investing behavior. Let’s say your portfolio has lost 20% in the past two months, a rare but not impossible occurrence. Do you buy more stocks at a good price, stand pat or exit in a panic?

What happened to the market? It wasn’t just the market—you were holding too many high-flying technology stocks like Palo Alto Networks and media stocks like Netflix. If you had sprinkled in a goodly number of established companies’ more stable stocks like Coke or Kraft Heinz, you might have lost 10% instead of 20%.

But if after several months high-octane stocks fully recovered from the selloff, you would only recoup only that 10% rather than 20%. Could you handle a treacherous ride to perhaps score really big bucks or are you more comfortable with a smoother, less harrowing experience? Samantha, the test-taking acrobat, might be enveloped in self-criticism if she missed most of the rebound.

What about Steve, the guy who couldn’t make up his mind over the steadfast Samantha or beauteous Maria?  He was lucky, a factor which frequently masquerades as investment savvy. His indecision led to doing nothing, which ironically kept him in for the rally. Are you a quick-thinking Samantha or a reluctant Steve? Know thyself and get comfy with your risk tolerance before you take your first plunge.

Let’s look at the four major types of risk. These entail the market itself, interest rates, inflation and unpredictable events.

Market Risk

We’ve just gotten a glimpse of market risk. Although bull markets that ramp up stock prices are more common than bear markets that drive them down, timing the peaks and valleys of the cycle has eluded even the most renowned of market seers. If you take a plunge when stocks are approaching the top, you will be vulnerable in the near-term. That’s why most market observers recommend you stay in the market for at least three years, so you will have time to regain any losses.

Interest Rate Risk

 Stock prices are very sensitive to changes in interest rates. The mortgage rate determines the cost of the loan homebuyers must pay back to the bank along with the principal amount. Today that rate is 7%, about the historical average. Lower rates translate into more home buying since more people could afford a mortgage loan, spurring sales of household products like appliances and furniture. Lower interest cost also stimulates business activity as more firms are able to pay for inventory and expansion. Higher interest rates contract business and real estate transactions, dampening the outlook for the economy and stocks.

Inflation Risk

 But every so often when times are good and people have more money in their pocket, competition for goods and services drives up prices to unaffordable levels. The government may raise interest rates to tamp down the overheated economy, eventually lowering prices to where people can cover their living expenses and companies can initiate projects. In the meantime, the slowdown in activity usually hurts stock prices.

Event Risk

Additional investment risks originate from outside the financial markets and cannot be prevented by the unsuspecting investor. Both of the two major risks of this kind are considered event-related. A common such occurrence is a sudden development that threatens to decrease the company’s sales and lower profits. This sometimes happens when the operations of a fast-food restaurant like McDonald’s or Chipotle are interrupted by a health scare. More calamitous were the two crashes involving Boeing’s vaunted 737 MAX 8 airliner in 2018 and 2019.  Although the stocks of companies impacted by tainted food usually recover once the problem is resolved, Boeing’s reputation and production have never returned to their pre-crash levels. Today, the stock sits at less than half of what it was then.

The second kind of external shock to stock prices is sometimes referred to as a “black swan.” A poignant example was the Covid pandemic. It kept people at home, devastated businesses and ushered in the bear market of 2022, when stocks lost 18%.

Risk Tolerance vs. Risk Capacity

Risk tolerance is very different from risk capacity. The first is a relatively stable personality trait, whereas your capacity to withstand risk changes over time as your life situations and financial needs change. If you’re planning to buy a home and anticipating a high monthly mortgage payment, your ability to absorb a market reversal will be reduced. To be sure, the most dangerous pairing of risk tolerance and capacity is the high risk-taker unprepared for a big financial hit.

So, What’s Your Own Risk Tolerance?

 Now for some fun in the interest of enhancing your self-awareness as an investor. Before you is the most widely used risk tolerance inventory in the world of finance. With only 13 questions, it yields a reasonably accurate picture of the test-taker’s ability to overcome the adversities inherent in stock investing:

https://www.kitces.com/wp-content/uploads/2019/11/Grable-Lytton-Risk-Assessment.pdf

Circle the best answer for you and then total up your score. There’s no reason to “cheat” or fret. Neither high nor low risk taking is inherently good or bad—whether higher or lower is more appropriate depends on the situation and context.

A Confession

Remember that Steve who couldn’t decide whether to take the stalwart Samantha or the evocative Maria to the prom? The guy who lucked out by freezing after a market meltdown, so he never sold at the bottom and rode the market right back up? That Steve was me. I took Samantha, the more deserving and the safer, as is my wont.