Do you know what your risk tolerance for investing is? In this week’s episode, Josh and Austin discuss risk tolerance and why it matters. There are many factors in to consider including timeframe, goals, and comfort level. The Invested Dads walk through these factors, why diversification matters, and how to keep on track. Listen now!
Main Talking Points
[1:24] – What is Risk Tolerance?
[4:08] – Example to Demonstrate Volatility
[9:48] – Dad Joke of the Week
[10:38] – Why Does Risk Matter?
[15:38] – Why Should You Take Risk?
[18:08] – Factors in Risk Tolerance
[23:41] – Portfolios for Risk Tolerance Levels
[30:32] – Keeping on Track
Links & Resources
Why Mistiming The Market Can Be Disastrous
Invest With Us – The Invested Dads
Free Guide: 8 Timeless Principles of Investing
Social Media
Full Transcript
Intro:
Welcome to The Invested Dads Podcast, simplifying financial topics so that you can take action and make your financial situation better. Helping you to understand the current world of financial planning and investments. Here are your hosts, Josh Robb and Austin Wilson.
Austin Wilson:
All right. Hey, hey, hey, welcome back to the Invested Dads Podcast, a podcast where we take you on a journey to better your financial future today. Josh and I are going to be talking about R-I-S-K. Risk.
Josh Robb:
All right. I love that game. World domination through the roll of the dice.
Austin Wilson:
Man, it’s a good game.
Josh Robb:
Yes.
Austin Wilson:
It’s a lot left up to those dice.
Josh Robb:
It is.
Austin Wilson:
Maybe. I don’t know if that’s how real politics around the world and global-
Josh Robb:
Game of chance.
Austin Wilson:
It’s a game of chance no matter how you roll. But actually, Josh, not really the board game Risk, although we should totally play that sometime.
Josh Robb:
Not only board game, but they have it on your phones now, and you can play people on the phone. It’s pretty cool. It’s free.
Austin Wilson:
So when you put yourself on Do Not Disturb in the office, you’re actually playing Risk?
Josh Robb:
I am dominating the world is what I’m doing.
[1:24] – What is Risk Tolerance?
Austin Wilson:
So let’s talk about investing risks. So most importantly, your risk tolerance, which we’ll talk a little bit, a lot really about what that means today. So according to Investopedia, risk tolerance is the degree of variability in investment returns that an investor is willing to withstand in their financial planning.
Josh Robb:
Okay. So that’s a lot of fun words in there.
Austin Wilson:
I know.
Josh Robb:
That’s a sentence you could say really fast and people will not understand what happened.
Austin Wilson:
But they think you’re smart.
Josh Robb:
Yes.
Austin Wilson:
Buzzwords for days.
Josh Robb:
So the big one is degree of variability in investment returns. What does that mean?
Austin Wilson:
Okay. So sometimes I’m nerdy. So I’m going to give it two ways. I’m going to do a nerdy one and a simple way. So first the nerdy one. In terms, I’m thinking of the variability of investment for returns kind of as the term volatility. So volatility is essentially the measure of the, another buzzword, standard deviation for investment returns. So standard deviation is a statistical measurement of how far either plus or minus a given historical return is away from its longer term average. So the higher the standard deviation, which is really the deviation from the mean, or the average, the more volatile a holding is expected to be, has been and really is expected to be going forward.
So to put it simply it’s big return swings. High volatility equals big swings, and that degree of the variability is directly correlated to that volatility there. So those are big up time periods followed by big downtime periods. And even though the longer term average may be the same as something more stable, the swings are therefore bigger and they’re therefore the volatility and the risk is there bigger.
Josh Robb:
All right. So variability. Variable, meaning there’s change.
Austin Wilson:
Change.
Josh Robb:
Ups and downs. And then the other piece of that is the degree of that. So as we were talking about the standard deviation, which is a fun formula calculation that you and I both had to learn, which is awesome, but that just means if you have a low standard deviation means there’s still variability-
Austin Wilson:
Right.
Josh Robb:
But it’s smaller.
Austin Wilson:
It’s up and down.
Josh Robb:
Closer to the mean. Closer to the average.
Austin Wilson:
Right.
Josh Robb:
So we’re saying risk tolerance has to do with the degree or how big the variability, which is the ups and down swings of investment turns that someone is willing to withstand in their financial plan.
[4:08] – Example to Demonstrate Volatility
Austin Wilson:
And you know how you take out the noise of having negative swings, is you square the number. Part of the calculation of standard deviation before that were getting too nerdy. That’s how your, a big upswing and a big downswing are captured the same way in a stand BB square calculation. Because if you square a negative, it’s a positive and a good square positive, it’s a positive math. So Josh and I put together an example, and I would like to walk through this example to kind of explain volatility and how that kind of works over time.
Josh Robb:
And we’ll try to put this image in the show notes so people can see what you’re talking about.
Austin Wilson:
Yes. So I created a very, this is completely high level and hypothetical, and it’s not even perfect, but it is still illustrates what I’m talking about pretty clearly. Suppose that you were investing for five years and there are two different kinds of investments. One is a low volatility investment. One is a high volatility investment. So Josh, you have the option of either one of these investments. So I’m going to tell you say you can choose one.
Josh Robb:
Yep.
Austin Wilson:
Would you choose the one that returns 5% in year one, followed by 6% followed by seven, followed by six, followed by 5% over those five years? Or would you choose the one that loses 5% and then is up 25% and then is up five, six and 1%?
Josh Robb:
Okay. So one spot is pretty it just kind of walks up and down about 2% as where it goes. The other one starts negative, but has some big years. And then some average years. Man, those are two totally different investment results from a standpoint of what you get while you’re waiting there.
Austin Wilson:
Right.
Josh Robb:
Doing the math in my head because you know, I do that.
Austin Wilson:
Yeah, that’s what you do.
Josh Robb:
I would say the low volatility, because you do get a consistency of returns, will probably give you a pretty good result without having to deal with all those up and down swings.
Austin Wilson:
Yeah. So surprisingly enough, both of those returns over that five year period, both of that sequence of returns would get you pretty much the same return. Which is amazing.
Josh Robb:
Yep.
Austin Wilson:
So suppose you put a $100, like a $100 bill into investment number one, which was the low volatility one.
Josh Robb:
Yup.
Austin Wilson:
You would end up with around $133 at the end.
Austin Wilson:
If you put that same $100 bills, or a $100 bill into investment number two or the high volatility one, you would have the same, roughly $133 at the end. So you’re averaging about a 6% compound annual growth rate. And that’s really, if you would just-
Josh Robb:
Wait, wait, wait compound into growth rate. What do you call that?
Austin Wilson:
CAGR.
Josh Robb:
That’s Austin’s favorite word.
Austin Wilson:
That’s a CAGR-
Josh Robb:
A CAGR.
Austin Wilson:
And college students this is not a kegger like college kegger.
Josh Robb:
No.
Austin Wilson:
This is a CAGR as in C-A-G-R.
Josh Robb:
Real life CAGR.
Austin Wilson:
So this is like if you were to take that rate and extrapolate it for all five of those years, that’s the number you would get.
Josh Robb:
Yup.
Austin Wilson:
So I think what you hit on was a very good point of really looking at first of all, the numbers ended up being the same and you wouldn’t really know that going forward-
Josh Robb:
Yes.
Austin Wilson:
But those swings are huge.
Josh Robb:
Yup.
Austin Wilson:
And really when you take the fact that I also calculated this, little nerdy, standard deviation that we had just talked about. So if you look at standard deviation, the low volatility five year period had a standard deviation of only about 1%. The high volatility had a standard deviation of about 11%. So drastically more volatile than the low vol example.
Austin Wilson:
So when you’re looking at risk adjusted returns, it’s a no brainer-
Josh Robb:
Yup.
Austin Wilson:
… to go with investment A or the low volatility, because you’re getting the same return for less risk.
Josh Robb:
Yep. And risk adjusted return. That’s saying, okay, when we look at what you have to deal with to get to the end result. Which one is worth dealing with that hassle?
And so coming back to these two examples, if you put in a $100 for each of those at the end of the first year, the first low volatility one had $105, because it got a 5% return. The other one lost $5. And so when you think from a financial advisor standpoint, do I have a client who is risk adverse where losing money will make them change their strategy, get out when they’ve lost $5 in this scenario and never have the chance to recuperate it?
And so that alone will make it harder to suggest the high volatility one, because I don’t want them to leave the strategy before has a chance to play out. Because again, have you played it all out, you end up with just a little bit more money, but for having to sit through those ups and downs.
Austin Wilson:
And an uncommon topic in the financial planning world and one that I’m sure we’ll hit on someday in a future episode is that sequence of returns for retirees-
Josh Robb:
Yes.
Austin Wilson:
… specifically at the end of your saving career is very, very important.
Josh Robb:
Yup.
Austin Wilson:
So if you’re in something that is, even though your overall long term average is about the same, that it’s a lot more volatile and you have some of those bad years, not necessarily up years, but the bad years, either at the end of your retirement, say, or at the end of your saving years before you retire-
Josh Robb:
Yup.
Austin Wilson:
Or-
Josh Robb:
Right into it.
Austin Wilson:
… the beginning of your retirement, where you’re actually utilizing that income that can drastically affect your outcome of your results.
Josh Robb:
Yup.
Austin Wilson:
So, yeah, that’s probably another topic for another day. But though that sequence of returns can be huge-
Josh Robb:
Yes.
Austin Wilson:
… even though the long term return is about the same.
Josh Robb:
Yeah. You could average 5%, 6% whatever you’re showing here. And if you have those bad years at the beginning, as opposed to the middle or end, it has a long term result.
Josh Robb:
So that’s risk tolerance. It’s the ability to tolerate that up and down swing. Risk, just from a high level, is the chance of that movement. Right?
Austin Wilson:
Yeah.
Josh Robb:
The risk is that you could have a fluctuation in your value. So risk, risk tolerance, okay, we got that. How does that, why does that matter? What does that have to do with investing?
Austin Wilson:
One big word. Success.
Josh Robb:
Okay.
Austin Wilson:
S-U-C-C-E-S-S, because there’s two pairs of two… lot of letters in there. Success. So staying in your risk tolerance. So if you’re okay with more risk or less okay with more risk staying within the band that you’re comfortable with, it’s not… it’s one of the most important factors in determining your chances of being successful in meeting your long term investment goals.
[9:48] – Dad Joke of the Week
Austin Wilson:
Wow!
Austin Wilson:
I feel like that’s been a really technical and deep intro-
Josh Robb:
Would say deep intro.
Austin Wilson:
So we’re going to do a dad joke of the week, a little early.
Josh Robb:
Okay.
Austin Wilson:
So Josh-
Josh Robb:
I’m ready.
Austin Wilson:
Put on your hat.
Josh Robb:
I’m on. Dad joke hat.
Austin Wilson:
We just got out of the COVID-19 bear market-
Josh Robb:
Bear market?
Austin Wilson:
So if you did not catch that episode, we talked about the shortest bear on record. Which it’s really a bear market, but I thought it was funny to call it a bear, like a teeny bear.
Josh Robb:
The shortest bear?
Austin Wilson:
A short bear.
Josh Robb:
It’s a Cub, like a Cub market.
Austin Wilson:
Like Yogi and Boo-Boo.
Josh Robb:
It’s a Boo-Boo market.
Austin Wilson:
So Josh in light of that-
Josh Robb:
Yes.
Austin Wilson:
What do you call bears with no ears?
Josh Robb:
Bears with no ears? I don’t know.
Austin Wilson:
B.
Josh Robb:
B? Because they have no E-A-R, no ears.
Austin Wilson:
B. No E-A-R-S. Yes.
Josh Robb:
Okay, I got it.-
Austin Wilson:
So next-
Josh Robb:
I like it.
Austin Wilson:
Let’s get back to it because-
Josh Robb:
Yes.
[10:38] – Why Does Risk Matter?
Austin Wilson:
… now you’re in a happy mood. You had your Dad joke of the week. Why risk matters? Let’s talk about that.
Josh Robb:
Yes. So Austin explained what risk tolerance is and why we need to understand what the tolerance is for each person. Why does that matter? And you said success. So let’s break that down. All right.
JP Morgan had a chart and one of the things they sent out to advisors that show some research that was done over the last 20 years. And they looked at mutual fund transactions and found that the average investor over the last 20 years had an annualized return of 2.5%.
Austin Wilson:
That sounds…
Josh Robb:
It’s low.
Austin Wilson:
Terrible. I can’t even talk.
Josh Robb:
Yeah.
Austin Wilson:
It’s so bad. I can’t even talk.
Josh Robb:
It’s a horrible, terrible and you mix those words however you want. In fact, during that same timeframe, inflation was 2.2%. So the average investor earned 0.3% after inflation or what we call the real return. That’s not good.
Austin Wilson:
That’s not good at all.
Josh Robb:
During that same timeframe as reference point the S&P 500, so U.S. stocks returned, 6.1% and bonds returned 5%. All right. And so then the question is, why did the average investor do so bad when kind of the two main assets that people use are up six and 5%, respectively.
Austin Wilson:
Right.
Josh Robb:
And they averaged 2.5. The big factor is reaction to market moves and by selling due to fear. So why does risk matter? It’s like you said, the ability to have success in your planning.
Austin Wilson:
Yeah, that’s right. So investing above your risk tolerance can have a large impact on your investment returns if it causes you to exit the market while your investments are down. So making those choices, like for example, we just experienced a bear market. The S&P 500 was down 33 and a half percent or whatever. A lot of people may have made very poor choices because they were in things that were too risky for their risk tolerance. And they sold when things were down. And that really impacted their… Like you’re locking in losses.
Josh Robb:
Yes.
Austin Wilson:
If you’re selling, when things are down.
Josh Robb:
Yes.
Austin Wilson:
There was a good article from thesimpledollar.com. We’ll throw that in the show notes as well. But in this article, they referenced a study that Fidelity did on the impact of missing the best days in the market. So here’s what Fidelity found out when they crunch the numbers.
Austin Wilson:
On a hypothetical $10,000 investment into an S&P 500 index fund from 1980 to 2018. So you’re missing the last year and a half or whatever. That’s 30 years. Yeah. So your $10,000, if you invested it-
Josh Robb:
About 38 years.
Austin Wilson:
Yeah. You invest in 1980 $10,000 into an S&P 500 index fund. Totally hypothetical here. But if you’re just in the market the entire time, ride the whole thing out, your $10,000 turned into $708,000.
Josh Robb:
All right.
Austin Wilson:
That’s pretty awesome. Right?
Josh Robb:
That’s great.
Austin Wilson:
If you missed the five best days of the market, five-
Josh Robb:
Okay.
Austin Wilson:
What would have been $708,000, if you were in it all the time, you missed the five best, your 708,000 became 458,000. That’s a big difference.
Josh Robb:
Wow.
Austin Wilson:
You miss the 10 best days in that 708,000 turns into $341,000. You missed the 30 best days that 708,000 turns into $135,000. And if you missed the 50 best days in almost, a 40 year period, your 700, what would have been 708,000, if you had stayed in, only with $62,000, that is drastic.
Josh Robb:
That’s crazy. So 10… Missing five days resulted-
Austin Wilson:
Yeah.
Josh Robb:
In a loss of 35% of what you could have had?
Austin Wilson:
Correct.
Josh Robb:
That is crazy.
Austin Wilson:
Five days.
Josh Robb:
And then missing 10 days is half. Half your returns by missing the 10 best days.
Austin Wilson:
Right.
Austin Wilson:
So another good reason to invest it is that the majority of the best stock market days throughout history have come in the midst of significant market downturns. So on top of the 10 biggest days on, in terms of gains, six occurred during the chaos in the early two thousands during the tech bubble burst and or during the 2008 global financial crisis and outgoing, great recession that we saw there.
So it can be very hard. It’s hard to get for people to get their mind around, but it is crucial to panic selling when the market is having issues and experiencing a lot of volatility, such as we saw earlier this year. So, as the saying goes, it’s all about time in the markets. So those all the days over that 38 year period versus timing the markets, because if you start trying to time the markets you miss those days.
Josh Robb:
All right. So that’s, I mean that’s mind boggling to think that if you miss just those handful of days, how much of an impact it has long term.
Austin Wilson:
It’s huge.
Josh Robb:
And that those days happen, six of those 10 days happen in the midst of the bear market downturn.
Austin Wilson:
Yeah. Right.
Josh Robb:
So even though the market’s dropping, those few days where you have an up day, which is our big up days, they help cushion your long term results through that volatility. That’s crazy.
[15:38] – Why Should You Take Risk?
Austin Wilson:
So Josh, why can, or why can we, why can we take risk? Or why should we take risk if there’s really chances out there to lose money?
Josh Robb:
Yeah. Biggest answer is there’s no free lunch, right? You hear them say that-
Austin Wilson:
You just said you’d take me out for lunch.
Josh Robb:
… now, actually right now there is because school programs have this lunch program, but that’s a whole COVID issue. So don’t, the saying, going though is you can’t get something for nothing, right?
And so if I need returns in order, so what are the returns therefore? You’re saving while you’re working and trying to grow your money so that when you retire, that will be sustainable, that you don’t need an income source outside of your investments to provide for you for the rest of retirement. And in retirement, you need to continue to invest so that that money can grow or keep up with inflation. So I need some sort of growth, even if I’m done accumulating to at least keep up with the cost of everything else around me going up in price.
So in order to get that return, there has to be some sort of risk involved, all right? That volatility comes or the return potential comes from the unknown factor of investing. Right?
When I buy into a stock, the reason why it fluctuates is the don’t know the outcome of that company. Will it be here? Will it be the same as what it is right now? Hopefully it’s bigger, which means it’s probably worth more money in the stock. Price has gone up, but the unknown is what causes in a sense of premium or an additional cost to it. In my sense, as an investor, a return on the unknown for lending the money or providing that capital for them to grow.
Austin Wilson:
Yeah. And that’s why you see very different rates of required return coming from everything from fixed income, which is very low required, very low return rates.
Josh Robb:
Yes.
Austin Wilson:
Yields are very low right now, but risk is lower. All the way to larger cap, blue chip stable equities with kind of middle of the road returns, but less volatility. And then things get more volatile in the rate of return that is required to compensate investors.
Josh Robb:
Yes.
Austin Wilson:
As you get smaller companies are more growth oriented companies gets even bigger.
Josh Robb:
Or new technology.
Austin Wilson:
New technology, yeah.
Josh Robb:
I mean, you look at something like Bitcoin. The chance of return is very not known.
Austin Wilson:
Unguaranteed.
Josh Robb:
I mean, it’s unknown, but the risk premium that they’re offering, there’s a lot of potential. If it turns out to be a new technology that’s adopted, there’s a lot of return potential. So you’re taking a high risk, high return chance with something like that. Again, not recommendations, but those are just some examples of how the more unknowns there are, the higher the risk, which usually means the higher, the return potential.
[18:08] – Factors in Risk Tolerance
Austin Wilson:
So there are a handful of things that go into calculation of risk tolerance. And those biggest factors are: timeframe, investment goals, income, and comfort level. So those all play a factor in determining someone’s risk tolerance.
Josh Robb:
Yes.
Austin Wilson:
Age can also play a role, but it’s not necessarily as important as your timeframe, because say you have… Here’s an example. Say you have an 80 year old person, they have a high age, but if their goal is to give money their grandkids, the timeframe is actually a lot longer than their life expectancy. So you may be able to be more aggressive with that portion of the money than a normal 80 year old person who wants that money to live on or whatever.
Josh Robb:
Yeah.
Austin Wilson:
So Josh, go in. Go through those factors a little bit. So start with timeframe.
Josh Robb:
Yeah. So that’s why we say timeframe instead of age, because age is relying on the person or couple that you’re working with. Their age in their timeframe, like you mentioned, may not be the same. They may take a bucket approach where each bucket of their money has a different timeframe, which means it has a different risk tolerance. So timeframe has to do with how long is that money able to be invested without a need on that portfolio, or without that ability that the unknown of what if I need access to that quickly. The longer the timeframe, the more risk you can take.
So if I’m a 20 year old investing in a 401(k) because of penalties and all the fun stuff that they have on those plans to encourage you to save, my timeframe as a 20 year old is I can’t touch that money without a penalty until 59 and a half.
Austin Wilson:
A long time. Almost 40 years.
Josh Robb:
So I have a long timeframe to let that money grow. So I should, at least from a risk tolerance standpoint, have a higher degree to accept risk than if I had maybe I’m a 55 year old looking to retire at 60. My timeframe is shorter, but that’s just one factor.
Investment goals is the next one. So what is this money for? So if I have some money set aside and I’m going to put a down payment on a house, that investment goal and the, when am I going to do that, the timeframe impact each other in choosing risk. I may have the ability to say, “I don’t care what goes on with ups and downs,” but if I’m going to need that money two years, and it’s for a specific reason where I’m going to need the full amount of money, a down payment, my risk tolerance just dropped dramatically-
Austin Wilson:
Right. Yeah.
Josh Robb:
… for that piece of money. Income is another factor. So again, going back to retirees, if I have other sources of income coming in my risk tolerance to watch or accept the ups and downs on my investment increases. And so if I have, if I’m working and I have monthly income, I don’t have a need or a burden on my portfolio. So my risk tolerance can be higher.
You see how all these, there’s not one that is by itself. They all interact together. And then the last one is hard. One that’s hard to quantify. It’s your comfort level. And so this is the one that you take science, which is all these other ones. You can just do a formula. Okay. How much income do I need? What are my investment goals? What is the timeframe? Whether the standards, what are the needs, all that can be done.
Comfort level. We have questionnaires to try to help derive or at least get that conversation going. But the comfort level is more just that conversation with a client and saying, “Okay, you’ve been around for a little while, you experienced 2020, and all the fun that’s happened so far. What did you feel during that timeframe? How did you react?” Or if they’re new to investing, give them some scenarios and kind of in a sense, flesh out that thought process of what do I do if I have a $100 and in the first year, it’s down a little bit. What is my response? Because that comfort level can override all those other factors, which we saw in that JP Morgan survey, they did is the average return for the average investor was low. And part of that had to do with the comfort level. They were in things that shouldn’t have been in-
Austin Wilson:
Right.
Josh Robb:
… and they got uncomfortable and were not able to stick it out.
Austin Wilson:
I believe that I’m going to establish a new trademark.
Josh Robb:
Okay, here we go.
Austin Wilson:
Here on this day, I’m going to say that we measure the comfort level in terms of the wait for it, cozy coefficient.
Josh Robb:
Cozy coefficient. I like it.
Austin Wilson:
So cozy. So how cozy are you?
Josh Robb:
How cozy are you?
Austin Wilson:
With what’s going on or what could happen? The cozy coefficient.
Josh Robb:
That’s probably the most important to keep an eye on-
Austin Wilson:
The cozy coefficient
Josh Robb:
… the cozy coefficient, because you may not be as cozy during different seasons of your life.
Austin Wilson:
Yeah.
Josh Robb:
So elections are coming up. If anybody didn’t know that, so elections are happening soon. That could change your comfort level. We have conversations with clients whose comfort level is different now than it was a year ago. This COVID-19 that could change your comfort level, having seen and been through stuff. So this is always something to keep an eye on. Yeah. My timeframe changes every year. It gets a little shorter for my goals, depending on what they are. My investment goals maintain relatively same, but they may change in sequence. So I may have a higher need for short term savings for a down payment for a house. But then that goal changes to retirement savings or college savings or whatever it is.
So my investment goals save relative the same. Income fluctuates, but is during your working career, pretty much consistent in that that is providing your safeguard for the need on the portfolio. But comfort level?
Austin Wilson:
Wildcard.
Josh Robb:
That is the anything could happen to change that it could even be a non-investment event that changes your comfort level for the risk you can take.
Austin Wilson:
Right.
Josh Robb:
You have a family member, you have to start taking care of and they’re sick. Okay. That puts pressure on other things in my life. And so my tolerance level just happens to be lower because that’s just one less thing I want out of my control. And so we’ve seen that where those types of things impact it. So it’s always important to keep an eye on that.
[23:41] – Portfolios for Risk Tolerance Levels
Austin Wilson:
So we kind of have established risk. What it is. What risk tolerance is and how that relates to you and how you invest. How do we put together portfolios or plans to kind of meet those risk tolerance levels or cozy coefficients, perhaps-
Josh Robb:
Yes. You love that. That’s your thing.
Austin Wilson:
I’m going to stick to that. That’s a cool word. So Josh, what are some practical levers that we can pull as people who talk about finance, who manage portfolios, who put things together to help people meet those goals?
Josh Robb:
Yeah. So first you mentioned knowing your risk tolerance. So it depends on who, what advisor you have and how they kind of frame that. There’s all different ways out there. You can give it from like a term of conservative to aggressive or you can, there’s programs out there that assign numbers to your level of high to low, or all different ways. It doesn’t matter how you do it. There’s no right or wrong. It just a matter of understanding where you land on that tolerance. Whether it’s a term, a number an asset allocation, but understanding where that is.
Once you know that tolerance, what you need to do is build a portfolio. And again, there’s so many unknowns. As advisor I don’t know what the market’s going to do in the next day-
Austin Wilson:
Wait what?
Josh Robb:
… let alone the next five, 10 years. Right? And so the things you need to do is you need to build a portfolio using historical data saying what has happened or how has this portfolio behaved and then extrapolate that photo cap.
Josh Robb:
That’s how it’s done in the past. Will I be comfortable going forward if these similar events happen?
Austin Wilson:
Right.
Josh Robb:
So a couple things you could do to help keep that in line with your tolerance is, the biggest one is diversification. You hear us talk about it all the time. The more diversified you are, the more you smooth your risk out because you’re not targeting just one in stock, one asset, one spot that, depending on what that does, your whole portfolio moves.
Austin Wilson:
Not a 100% Bitcoin?
Josh Robb:
Not a 100% Bitcoin. And we always say to know you’re fully diversified is to have something in portfolio you’re always mad at. That means you’re diversified because they should not all move in the same direction. If the stock market’s up and everything, your portfolio is up the exact same you’re not diversified.
Austin Wilson:
Yeah.
Josh Robb:
There should be something doing something a little different. And that’s where the diversification comes in.
Asset allocation. So we’ve talked about, part of the risk challenge is how much is in the more aggressive stuff, like stocks and how much is in the more preservation side, like fixed income and cash-
Austin Wilson:
Yup.
Josh Robb:
… and those types of things. Knowing your allocation and what your tolerance is, matching your goals that’s key and that’ll help you. That’s the biggest. Diversification allocation really help define your risk tolerance and keeping it in there.
But what’s also important is that as an asset location. So is that, where did I put my items? I buried it in the backyard. No, asset location in some asset, like stocks do better in like a tax deferred account-
Austin Wilson:
Right.
Josh Robb:
… because if there’s a lot of capital gains and turnover and trades, you don’t want to be paying that along the way. Whereas a municipal bond that has tax free income would be good in a taxable account.
Austin Wilson:
Exactly.
Josh Robb:
So location means, based on all the accounts I have, which piece should be in which account. And so, you or your advisors should really think through those pieces as well.
Josh Robb:
After you get your allocation done-
Austin Wilson:
Right.
Josh Robb:
… that’s the second spot. Okay. Now I know what I need. Where do I put it?
Liquidity? When it comes to risk tolerance, liquidity is important because during the stressful times, like March of this year-
Austin Wilson:
Wait, was that stressful for you?
Josh Robb:
That was… I got some gray hairs from that. That is the time where people say, I need some cash.
Austin Wilson:
Yeah.
Josh Robb:
You know, my company is closing up I’m unemployed or whatever happens your life, liquidity means the ability to get to your cash quickly. And you should… doesn’t mean everything has to be extremely liquid, but you should know how much liquidity you have. How quick can I get to cash and how much cash can I get a hold of?
Austin Wilson:
And that’s another plug for another episode that we’ve talked about doing for a while. It’s about an emergency fund.
Josh Robb:
Yes.
Austin Wilson:
And if you have a fully funded emergency fund and you don’t have to pull money out of your investments in crunchy times-
Josh Robb:
When things are down.
Austin Wilson:
Like March.
Josh Robb:
Yes.
Austin Wilson:
Then you’ll be better off in the long run and yes, stay tuned in the future we will have an episode about emergency fund and what that should look like for different points in your life.
Josh Robb:
Yes, because it varies throughout your different life stages.
Austin Wilson:
It does.
Josh Robb:
A bucket strategy is another way to help bring your risk tolerance in line. And I mentioned that earlier buckets, meaning each bucket, which is just a term to describe a group of things put together in one spot for a purpose-
Austin Wilson:
It’s not like actual 5 gallon buckets.
Josh Robb:
Yeah. You don’t actually, yeah, you don’t put them in. So I may have a bucket for my short term goals. So I’m not going to be risky with that. I may have a bucket for midterm goals. So things that are happening five to 10 years down the road, then I may have a bucket for long term goals. Each of those buckets are invested differently so that each of my risk tolerance for that timeframe matches. But then my overall, we take all those buckets together should not exceed my ability to tolerate that as a whole.
Austin Wilson:
Right.
Josh Robb:
Because not everybody looks at things as buckets. If you can’t draw a line and say this return, if it’s down 20% because it’s long term, I’m not going to freak out. Not everybody can do that.
Austin Wilson:
Right.
Josh Robb:
Whereas, or if you look at the short term and say, when the market’s up 32% and I don’t get any of that, I’m not going to freak out because that’s not what it’s here for. You have to fully understand each bucket’s purpose, but that is a good strategy for people who do that.
Holding weights. So it’s not working out, it’s holding weights. How much, yeah, how much of each of my holdings should be in my portfolio? So when we talk about risk tolerance, let’s say I have some company stock and they keep giving it to me, I ended up having 20% of my allocation in one stock.
Austin Wilson:
That’s a lot.
Josh Robb:
That’s a lot. And that’s from a risk tolerance standpoint, what happens to that company you’ll really feel in your portfolio.
Austin Wilson:
Exactly.
Josh Robb:
So knowing how much of any of my one holdings do I want. Even cash.
Austin Wilson:
Yeah.
Josh Robb:
If I hold 20% cash for a long time, that will have an impact on my portfolio.
Austin Wilson:
Yup.
Josh Robb:
And so understanding how much weight or what percent of my portfolio should be in each of my holdings is big when it comes to risk tolerance.
Austin Wilson:
That kind of ties into the diversification.
Josh Robb:
Yeah. It comes back to that. Yeah.
Austin Wilson:
Because, yeah, if you’re not diversified, if you have too much-
Josh Robb:
Yes.
Austin Wilson:
… in any, even one… even sectors.
Josh Robb:
Yeah. And even as good as it does, if you say, well, this company is doing awesome.
Austin Wilson:
Right.
Josh Robb:
Yeah. But so did some other companies that did great until it didn’t and some people got stuck with a little bit too much. GE is a good example-
Austin Wilson:
Hate to be the Enron employee.
Josh Robb:
Yes. Yeah. And those are the great examples.
Austin Wilson:
Right.
Josh Robb:
GE is a, I think a great story because Enron, they went bankrupt. They’re gone-
Austin Wilson:
Yeah.
Josh Robb:
But GE is still here.
Austin Wilson:
But they’re not worth anything yet-
Josh Robb:
But they’re nowhere near what they were. And it’s the company’s still here. It’s not like something crazy happened. They just stopped being awesome.
Austin Wilson:
Right.
Josh Robb:
On from a return standpoint, investment standpoint, and people got stuck with a lot of holdings because for a longest time it was paid a nice dividend. It grew consistently until it didn’t sell.
[30:32] – Keeping on Track
Austin Wilson:
Yeah. So I kind of feel like between all of these different ways that you can build your financial plan, it’s like a triangulation, it’s a lot to put together where you’ve got to work out diversification and allocation and liquidity and buckets and all, making sure your weightings are in line. How do you make sure that those are not getting too out of whack too frequently?
Josh Robb:
Yeah. So the first one is setting a periodic review and sticking to it. That’s huge. Whether it’s you or what we suggest is having an advisor along with you, someone to help you along with that process. But that’s key because things change. And if you’re not reviewing it periodically. And when we say that, I can’t tell you what the exact timeframe would be. Everybody’s different, but at least once a year, doing a check on how everything is. Some people do it more frequently. Doesn’t mean you have to change anything, but you’re actively looking at it say, “Okay, how do I feel? How are things gone? Am I still happy with this?” So that’s the first one is having the review, having an advisor that you trust. Trust is huge because these are big deals. We just showed you what happens to average investor if you make some of these wrong decisions, it really mute your chances of success, especially when it comes to long term planning.
So having an advisor you trust is huge and having, making sure they’re competent in what they do, what they’re planning, right? It’s not just investing, but it’s planning. If you don’t have one, we’ve mentioned before, you can reach out to us. There’s a link on our website. If you just want to check out and see kind of how we do things, that’s there for you. But regardless of who you use, trust is huge. And having an understanding, don’t just rely on your advisor. All right. They’re human being. They can make mistakes too, make sure you understand and agree with what is being done in that portfolio.
Austin Wilson:
And as always check out our free gift to you. It’s a brief list of eight principles of timeless investing. These are overarching investment themes and meant to keep you on track to meet your long term goals. Tied directly in with what we were talking about today. It’s free. Check it out on our website, Josh, how can people help us grow this podcast and continue to help people?
Josh Robb:
Yeah, definitely subscribe that way you’ll get an alert. Every time we drop a new episode on Thursdays, leave us a review on Apple podcasts. That’s always great. Helps us show up more often in ranking so that other people can find us and be helped just like you guys.
If you have any ideas, we love doing topics that people suggest, because we know that’s something that they’re interested. So send us an idea at hello@theinvesteddads.com.
And then also if you know somebody who was talking about risk tolerance, because it comes up all the time in conversations, then feel free to share this episode with them and let them know that we had a topic and walk through it.
Austin Wilson:
All right, well until next Thursday, have a good one.
Josh Robb:
All right. Talk to you later.
Austin Wilson:
Bye.
Outro:
Thank you for listening to The Invested Dads Podcast. This episode has ended, but your journey towards a better financial future, doesn’t have to. Head over to theinvesteddads.com to access all the links and resources mentioned in today’s show. If you enjoyed this episode and we had a positive impact on your life, leave us a review, click subscribe, and don’t miss the next episode.
Josh Robb and Austin Wilson work for Hixon Zuercher Capital Management, all opinions expressed by Josh, Austin or any podcast guests are solely their own opinions and do not reflect the opinions of Hixon Zuercher Capital Management. This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Hixon Zuercher Capital Management may maintain positions in the securities discussed in this podcast. There is no guarantee that the statements, opinions or forecast provided herein will prove to be correct.
Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses, which would reduce returns. Securities investing involves risk, including the potential for loss of principle. There is no assurance that any investment plan or strategy will be successful.
