Money Talk

Episode 02

Determining Your Risk-Reward Level

Ed and Chuck help you determine your risk-reward levels as it pertains to investing. The 80/20 debt rule. Debt as a moral failing? Budgets? “I have no debt”. “I have no cash”. The real definition of “investment risks”. The psychology of investing. Fear of failure. Losing, winning, not even in the game.

Welcome to our listener-supported podcast, Money Talk, uncompromised absolute financial truths behind financial perceptions with host, Ed Sutkowski and Chuck LeFebvre. Let’s listen in.

Ed Sutkowski: Hello I’m Ed.

Chuck LeFebvre: I’m Chuck.

Ed: Today’s podcasts will deal with determining your risk/reward level. We’re in the asset accumulation stage versus the management and the transfer stage. Beginning of the accumulation process and your first determination is, take a look at the mirror and determine your ability to take financial risks. How much wealth do you have, how much money do you have in your 401(k) plan, your IRA, and your savings account, and your rainy day fund, and most importantly, what is your debt tolerance?I’ve run into folks that find that debt on their residents is close to death. I can’t live, I’ve got this mortgage on my house. Bearing in mind that person can deduct that interest and views that as I’m not sure what. If you cannot tolerate debt, your rewards are not going to be significant over a very long period of time. On the other hand, I’ve run into folks primarily real estate developers that have debt out the wazoo but no equity at the other end of the spectrum. If things go bad, they’re out of business.It’s really a continuum between no debt to all kinds of debt, and I like to use the 80-20 risk/reward ratio. In other words your debt should never exceed 20% of your total assets. We’ll get into the 80/20 issue but it is something that you must be able to identify and start, not necessarily investing in the stock market, but do it on paper.Let’s assume you theoretically put $10,000 on paper and see how you would do over a period of time. In other words, and the elevator starts at the ground floor. Don’t try to get to the top of the building in your first investment. Your expectations should be in line with your station in life, your age, your willingness to take risk and your cash flow requirements.I’m not saying have a budget for everything- and by the way, I know some accountants would like to tell you what’s what’s occurred that have a daily journal of everything they spend, including it on gum and gas. Well, that’s fine but you’re devoting all sorts of time to really telling what has happened versus focusing on what you should be doing in the future.In other words, delegate any or everything that someone else can do to that someone else, and focus on what is meaningful and insightful and your risk/reward tolerance, how you handle debt, what kind of cash do you have, your debt equity ratio. Then you can talk about investing, but remember try that paper and start with the ground floor. Don’t try to get to the top of the Empire State Building in one full swoop.

Chuck: I have a confession to make, which is that there was a time in my life that feels like it was yesterday; although, I think it was maybe several decades ago when I in fact kept a ledger of every penny that was spent.

Chuck: I can say that that is probably a worthwhile exercise. Maybe even a critical exercise for people who really do have very limited income and need to budget carefully and make sure they don’t get over their skis. Yes, you see people do that who really are doing it primarily because it’s it’s self-gratifying, and not because it’s an exercise that really is helping them manage their budget.

Ed: Well, I wanted to talk about managing a budget. Now, let’s assume that you’re an entrepreneur and you have a closed held business organization. What to do? You take dough W2 income throughout the year, you get one check at the end of the year and this forces you to quote borrow before you spend. It forces a bit of discipline on you and it works over along period of time. I am accustomed at getting one check, if at all, in December of the year. That has worked but it’s a little bit over the top, but nonetheless, think of forcing something to happen on your investment portfolio.

Chuck: I would say that if there’s one conversation that comes up repeatedly in talking to clients, particularly clients who are looking for new ways of managing their assets, ways of managing their tax liabilities, ways of growing their assets and are looking for insights from us. It seems like this conversation about taking on debt seems to me it’s the number one conversation that comes up.Part of that is because of what you alluded to before, where there was a very widely shared belief in the population and its part of the fabric of our society that suggests that the incursion of debt is some type of a moral failing. Continuing to hold the debt past a certain period of time is also some type of a moral failing. You’ll find people who can afford to have debt, who can service the debt, who are absolutely better off taking on debt, who have no risk of getting into a default just having a psychological block, where they just will literally keep them awake at night if they take on debt.Again, that goes back to this question of, can you, as an individual get over that particular mental hurdle? Keeping in mind that some people can’t. Lesson number one is some people cannot get over that mental hurdle. Lesson number two is that for many people, it is a purely mental hurdle and not something that is very grounded in reality.

Ed: You don’t know how correct you are. Visiting last month was a long-term client of the firm and every time they come in for a checkup every year, there’s a couple- gazillions of dollars in cash. Not in a checking account, but in maybe a CD with very low rates of return, but a fair amount, I should say in a checking account. Yet, this individual is an entrepreneur, making a lot of money, a lot of income every year, creating a lot of jobs, a lot of value, but yet, the bulk of the investment other than the business is cash, which is not an investment in that our definition of it. It doesn’t necessarily follow that the entrepreneur will have debt associated with the business, but his fear was failure. If this company ever goes down, I want to make sure the company can pay its bills. Well, okay, fine. You never then say to that person, “Why do you have all that cash?” Because he’ll look at you or she’ll look at you and say, “You’re nuts. Why would you ever have any debt?” Again, it’s the curve eyes. Is it blue eyes, green eyes and on a continuum, from no debt to an 80:20 ratio debt, which most people should be comfortable with. If you know where your cash flow is going to pay your interest, well, what’s the bad deal is the bank is going to loan you money. By the way, the only reason the bank will loan you money is because you don’t need it. You show me a banker that will loan you money when you need it, and I’ll show you someone who is not being candid with you.

Chuck: Or no longer a banker.

Ed: Yes, that’s right. If they’re going to loan you money, I’ll borrow it. Depends upon the rate, and by the way, I’ll shop the rate. I’m not married to the bank, I’m married to rate of return.

Chuck: It seems like we see that a lot where you have either entrepreneurs or you see this a lot in farming families, where there’s a war chest of cash sitting in the bank somewhere. That cash has to be there because you never know when you’re going to need it. Now in the case of these farming families, a lot of times it’s because they’re hoping someday a farm will come up for sale and they want to have money sitting around so that they can make a purchase if they have an opportunity to make a purchase. It all does come back to the same thing, which is an aversion to debt, which is a type of having an aversion to what I’ll call perceived risk, which is not always the same thing as actual risk. I think it’s worth pausing for a moment and talking about this idea of risk because that’s a word that people, when you’re raising children, will use it every day life talking about the risk of crossing the street. People will also use it when they’re talking about their businesses that they’re running, they’ll refer to business risk. They’ll talk about it with respect to their investments and then the investment professionals will use that term risk. In these different situations, risk can mean different things and sometimes dramatically different things. Depending on what the context is, I think sometimes people have a great deal of misunderstanding of exactly what risk is. In fact, even in everyday life, you look at the research that’s been done by these behavioral economists. It’s pretty clear that even in everyday life, people are very, very bad at assessing risk, even outside the financial context. There’s all kinds of heuristic misjudgments that occur in our brains. Here, when you’re talking about the investment world, this is something that can come down to math. It’s something that you can get a real answer for. When we talk about risk in the world of investing, the way that term is used by investment professionals is what they are referring to is something very specific. It’s a mathematical concept that refers to a measure of volatility of an investment, either a particular investment or a whole portfolio of investments. Specifically, it’s talking about the fluctuation in the investment value over a short period of time. Now, most people, when they think about investment risk, what they’re thinking in the back of their mind is they’re thinking about losing money, versus this mathematical concept of risk. That’s talking about something very, very specific. In other words, the fluctuation of prices that occur over a short period of time.

Ed: Let’s give me an example of think of this. Let’s assume Peter has $100,000 to invest. He makes a great bad bet and is now 150,000. Now, Peter also made a bad bet and he lost $50,000. Why is the loss of $50,000 an example, more difficult to stomach than the gain of 50?

Chuck: That’s one of those things that these behavioral economists have studied. They have determined that if you lose, let’s say, $50,000, the emotional impact of that loss is approximately double what the emotional impact would be of gaining the same amount. They’ve been some very specific experiments done by this, where they will put people in an environment where based on decisions that they make, they have the opportunity to lose. They typically don’t have all kinds of money to throw around in these experiments. They’re talking about smaller amounts of money. What they will find is that people will accept twice the risk in order to– they’ll be twice as likely to avoid taking a risk if the consequence of that is going to be losing $1, versus if the consequence is going to be the potential of gaining $1. You’re right, in the example of this investor, he loses $50,000 on one investment, he gains $50,000 on another investment. The one that’s going to stick in his mind, even though he’s broken, even here is this is going to feel like a net loss to him emotionally. That will drive the way his decisions are made going forward. If he entered into both of those investments, it’s based on the same assessment of the perceived risk of each of those investments. What he’s going to do at the end of this experiment where he’s lost 50 on one and gained 50 on the other, is he’s going to emerge from that and say- become a more conservative investor moving forward because it’s going to feel to him like he lost money overall.

Ed: I think the example again, one person one investment, made 50 one year and lost 50 the next year on $100,000. Well, the third year with the guy the investor that lost the 50 he’s got to make back– has very terrible 100%. He’s already got 50 to deal with. He’s got to make 100% on that 50 to get back to even. First the guy that won the same guy, he made 50,000 which is a 50% on the $100,000.

Chuck: Right. When you’re talking about investment returns that happen in series as opposed to being in parallel, if you’re talking about losing 50% of your investment in a given year. Then, yes, in order to make up for that, you have to gain 100% in the next year. In that context, this heuristic that’s been examined by the behavioral economists actually make sense that there is a two to one ratio there.

Ed: That’s not addressed. They don’t say that. The reality is I got to make 100% on the 50. Forgetting about everything else that’s so– Remember we’re getting a better, what is simple, make it simple and people don’t seem to want to do that. Now the other issue is, let’s assume for a moment that you think an investment would be terrific. Let’s say a planet fitness. If you went ahead and bought $100,000 worth of planet fitness and it did real well, oh, that’s great. Let’s assume you are going to buy $100,000 worth of planet fitness and you didn’t and it did real well, how do you feel?

Chuck: That lost opportunity is another thing that causes people to feel they’re missing out. Of course, they did actually miss out but that drives behavior in a way that is also– For instance, you could have had a perfectly good investment portfolio that you invested in instead of planet fitness. Let’s say planet fitness went up by 50% and you had an investment portfolio that went up by 40%. In a rational world, you should feel very, very happy about getting a 40% gain on your investment portfolio, but again, it’s going to feel like you missed out on something because there was an opportunity that you missed out on there. There, again, you see this quite often with people who are always looking over their shoulders that the grass is always greener on the other side of the fence, so to speak.

Ed: They could be envy. You just want to make a little bit more than your sister’s husband. The other side of that is a way of getting over that difficult area, that is forgetting to make an investment, is think in terms of, how would you feel if you had made the investment of 100,000 in Planet Fitness and went to zero? In other words, you can get over the psychological problem by saying, “Okay, it went up, but how would I feel if it went down?” The idea is the psychology of investing requires you to know you and start at the first floor of the elevator, not at the top floor and make sure– By the way, you may be the person that should never invest in the stock market, never invest in firms and that’s okay. It’s what are you about? What can you be passionate about?

Chuck: This is a great example, I think, of where there’s a great benefit of understanding the difference between what in the investment world among professional investment advisors and analysts is referred to as risk, versus on the individual experience what you think of as risk. As an example, if you were working with a professional advisor who went through a process with you and engaged in a risk analysis and decided you were someone who was not going to do very well emotionally with the idea of losing 100% or let’s say 70% of an investment you make in something like planet fitness. We’re just going to pick on planet fitness for a while here. That analyst will actually be looking at the statistics having to do with the performance of that particular stock and will say, “That’s a very volatile stock,” and its value goes up and down very rapidly. Therefore, I’ve interviewed Eddie and I’ve determined that he does not have a very high risk tolerance and so this would be a bad investment for Eddie. Because in that person’s mind, the rapid fluctuation of pricing is the equivalent of risk versus– I think that this is critical. For you as an individual, you’re thinking about it in a similar way but you’re not thinking about it in exactly the same way, because the way you’re thinking about it is that you have a time horizon in mind. For you, you might really not care what happens to that for the first five years, or the first seven years, or the first ten years. What you’re really worried about is, whatever that time frame is, that may be something that you aren’t really even self-aware enough to comprehend on your own, but whatever that time frame is, what you’re really looking at is, “Did I lose money or did I fail to capture the money I could have made when that clock,” however long we set that clock, “runs out?” One of the things I think is a very, very difficult thing for a person to do because it involves a certain amount of self-awareness that most people are not trained, practiced, or coached in, is to understand when is that event going to take place in the future where you’re going to look at those numbers on the sheet and say, “Well, this is the meaningful period of time where I’m going to gauge whether I was successful or not.” In my mind, that is the most important thing for you to know. That drives what is really your risk tolerance which is not the same thing as what is going to come out on a survey that you do with an investment advisor.

Ed: The psychological testing, oftentimes it’s flawed because you’re different than the numbers that’s expressed. In this issue of time horizon, just logically the younger you are, the greater the risk that you can afford to take.

Chuck: True.

Ed: People don’t focus. “Well, I’ll have that money. I got to buy a new TV, you got to buy a new car.” You need a new car for what? You get from A to B, so you have a new– You’re going to lease a car or you’re going to buy a new car that’s going to go down in value at 20% when you drive it off the lot. The furl of self-gratification is difficult for the younger person, but that’s the person that should be taking the risk. It’s upside down. Jack Bogle and others have said this ratio of age and percentage, in other words if you’re near retirement age, you should have only 20% in stock and 80% in fixed. In other words, all of these ratios, all of these teachings from a psychological testing point of view don’t apply to you. It’s how do you feel and are you willing to take a risk. Bear in mind that this whole asset accumulation process is nothing more nor nothing less than a gain.

Chuck: Just yesterday, I was having a conversation with an investment advisor who was in charge of managing the assets inside a trust. This is an investment advisor who’s not the trustee of a trust, there’s a bank that’s appointed as the trustee. This adviser was expressing to me the fact that he had just had an argument with the trust officers at the bank, because the beneficiary of this trust was someone who was in his 80s’ and the portfolio was very, very aggressively invested. It was 100% equities, this investment portfolio for someone who’s 80-years-old. The Bank Trust Department was looking at that and they were saying, “Listen, for someone this age, that is way too aggressive to have it as an investment portfolio.” They were just looking at the age, they were not looking at the fact that for this particular person, the beneficiary of this trust, those assets were really not intended to be used by that person during his lifetime at all. The idea was to just let that fund grow and be available to be inherited by the next generation. In that situation, what’s the time horizon? Well, it’s really the retirement age of that person’s children, not when this 80-year-old– His plan is to never pull on that money. I do believe that what we see quite often when people are planning for their retirement, you might talk to someone who’s 25-years-old, “When is your retirement going to be? Well, I’m going to retire at age 65. Well, I might have a hard time retiring at age 65, it might have to be 67 or 70.” People automatically assume that, “When I hit retirement age, that means 100% of the account that I am accumulating now needs to be available to me in cash to withdraw.” The truth of the matter is, hey, when you hit retirement age, you still have maybe 20 or 30 years that you have to live off of that. Which means you’re taking a tiny percentage of that fund out each year. Hopefully if you want it to last that entire period of time. One of the things where I believe that people and and investment advisors are actually very guilty of this, of advising people towards being more conservative than mathematically they really need to be. They do that, for the protection of the investment advisor. I’m going to make a few enemies here. The truth of the matter is that these people who work in that industry, who are providing advice to investors, they know that– These two scenarios that we’ve talked about, the one where someone loses money, versus the one where someone sees that they lost out on a game. The one that’s going to make them angry, or the one that’s going to make them think about filing a complaint against their investment advisor. The one that’s going to make them think about moving their business elsewhere, is that first example where they actually lose money. These investment advisors, that’s what they’re worried about. Is having a client who’s upset about losing money, thereby either taking some kind of legal action against the advisor, or moving the money somewhere else. Or giving a bad review on Yelp or wherever you do these reviews. [crosstalk]

Ed: Talking to your friends.

Chuck: Talking to your friends, bad mouthing them around town and so far. What they do is they scale back the aggressiveness of these investments, at the risk of not meeting the goals that need to be met for that investment portfolio. When people, getting back to this concept that we started the conversation with, with risk, that’s part of the risk. There’s a risk involved in not meeting your goals, and you have to weigh that against the other risks that people typically think about. People think about the risk of investing and there– I will say until I reach my grave. That when most people who have not received formal training and investment management talk about investment risk. That what they’re referring to is the fear of losing money, or not having as much to pull out of the investment as what they put in when the time comes where they make a withdrawal. In other words, they’re worried about– The phrase is always, “I’m much more concerned about the return of my money than the return on my money.” I’ve heard people quote that to me, many number of times.

Ed: It’s this issue, the fear of failure.

Chuck: It’s the fear of failure, and a specific type of failure. That is a risk and I think part of what, hopefully, over the course of these podcasts, will help educate people as to and people can educate themselves, by doing their own reading and research on this, is that, that particular type of risk is the easiest risk to manage. I would argue. Over a long enough time horizon, no matter what you’re invested in, assuming it’s not World Comstock or Enron, or something, or an individual investment that just goes belly up. If you are able to stay invested long enough, the risk of an investment disappears merely through the passage of time. If you’re talking about the risk of losing money, the risk of not meeting your goal gets greater and greater, the longer your investment horizon is. If you have not allocated things correctly at the beginning.

Ed: I think of a government imposed guideline on withdrawals. I think of the bulk of the assets that are currently in investing that I’m familiar with are in IRAs, Individual Retirement Accounts. When an individual hits retirement age, they transfer plan to plan out of their tax qualifying arrangement into an IRA. We know that- we hear about this required and minimum distribution date at 70-and-a-half. Now, that’s a discussion maybe that will be extended, but at someone at age 80, the amount that is required to be distributed is only 5.13% of the amount. The issue that folks always think of, you hit retirement is, you’ve got to have cash. No, the government has said, “Look, we’re going to require–” By the way, there was a time where that wasn’t in existence and you could defer that for years and years and even die and wouldn’t be taxed in your estate. That isn’t the case now but they’ve said, at age 80, you must take out 5.13% which is a recognition that you don’t need all cash, but we seem to avoid that. The government has suggested you don’t need all cash when you can remain invested until whatever.

Chuck: That is a pretty light pull on an investment portfolio to talk about pulling 5% out and that’s at age 80. When you’re required to start taking smaller percentages out at age 70-and-a-half, those are very, very easy. You’re not talking about liquidating your entire portfolio.

Ed: That’s right. People perceive that they must have the cash– we need the the cash. Peter and Paul, you don’t need the cash, remain invested because as you pointed out, the longer you remain investment, the lessening of the risk. If you’re trying to turn around in six months, you’ve got all kinds of risk given the volatility of any kind of an investment. If you’re talking about 20 years, 30 years, 40 years, 50 years, you’re going to come out all right.

Chuck: I think that what people really need to think about when they’re beginning the investment process is think very clearly. I mean very clearly, about when they truly will need to pull money out of that investment and how much they need to pull at.

Ed: Most importantly, how much do you really need? Remember, you’re not going to get slim as much as you did when you were working, or your spouse was working. You’re going to have real estate probably downsized, you’re going to buy a larger home when you’re 80 than you had when you were 50. The point is, you’re living–I understand it’s about two-thirds of what you needed before that’s separate to variation. Statistically, you need about two-thirds of what you were making during your useful economic lifetime.

Chuck: People who are fortunate enough to be able to save substantial amounts of money or they have other sources of post-retirement income beyond this investment portfolio that they’re building. They really need to be cognizant of the fact that their real-time horizon might extend their lifespan. I was just talking to a client yesterday who said, “You know, this plan we’re talking about might outlive the planners.” I said, “Well, yes, that’s exactly what we’re trying to do.” That’s the goal here, is to have a plan in place that extends beyond your lifetime. If that’s the case, then the investments should reflect that. This is a place where I really believe that people need to do their own math if they can, if they’ve got the skills to do that and do their own very hard thinking about this. They will be guided by virtually anyone in the investment community to be a more conservative than they may ultimately decide is right on their own. At the risk of having someone sue me over the comments being made in this podcast, this is an unorthodox sort of statement to be making. Rather than saying, “This is what you should do, Ed,” I’m just going to tell you, “This is what I’m doing.” What I’m doing is that when I retire, my investment portfolio will be 100% equities. It will not be an 80/20 or some kind of–

Ed: 60-40, 50, 50 whatever.

Chuck: No, because my idea is upon retirement age, that is still a long term investment on the day of my retirement. My little needs to come out.

Ed: My favorite, at age 80 you save 20% in equities, and 80% in fixed. The bottom line is I see it, in summary, is that number one, you got to be focused on deferring self-gratification. You don’t need all the money now. Number two, making an investment decision, you have to make the decision, because if you make the decision and it goes south, you have no one to blame and you just move on. If you rely upon someone else to make the decision, and it goes south, wow, you can’t handle that. Finally, if you have not made a purchase and the stock just goes to the top of the building, think of what it would be like if you had made the purchase and it went to the basement. Next time we’ll be visiting about the Psychology of Investing. I look to visiting with you folks next time.

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