Risk Appetite – Don’t consume the Sh*t they feed you
The great thing about finance is that it’s really not that complicated. A lot of what I write about is simple: invest your money in stocks, make sure you’re keeping under budget, don’t run off to vegas and think that you’re going to make your retirement savings appear at the roulette table. And for the most part, people who’ve studied finance will agree with what I have to say on this blog. But when it comes to risk appetite, I’ve decided to go very much against the mold. #fuckthehaters
The simplest definition I could come up with for risk appetite is, “How much risk an individual can stomach before they decide to not pursue the risky activity.” To give you an example, let’s talk about my relationship with bungee jumping. The risks of bungee jumping (not being securely fastened, having someone push me off the edge before I’m fastened, hitting the ground/water, etc.) far outweigh the benefits (what benefits? Being that close to death is not a benefit, thank you very much).
I’ve discussed this concept of risk and reward in previous posts, but today we’re going to be discussing the concept of risk appetite when it comes to your finances. And to be frank, most of what you’ve read/been told is absolute garbage. Buckle up, cuz we about to break through the bullshit.
Risk Appetite – A lie much like Santa Claus…
Any financial advisor worth his/her salt is going to discuss risk appetite with you. They’ll sit down at your dining room table, with a fancy briefcase and slight air of superiority. Once you’ve poured them a beverage and gotten your pleasantries out of the way, they’ll have a very soft conversation with you around your risk aversion. If they’re fancy, they’ll have you take a quiz (mind you, these quizzes are absolute tripe because you’ll know what the questions are getting at…)
And then they’ll talk about your investment options, expected return vs. reward, yaddah yaddah yaddah. And then they’ll tell you one of the most detrimental things your finances will ever have to suffer through:
“Whatever investment choice you make, you have to make sure that the amount of risk you’re taking will allow you to sleep at night.”
…and that’s where they’ll get you. Those six fucking words could be the difference between you retiring on time and being a 75 year-old bagger at the local Whole Foods (not shaming, I just don’t think that’s ideal.) It’s funny, because you wouldn’t think that phrase would be that perilous. But just like Snooki, just because it’s small doesn’t mean it’s not dangerous.
And the reason it’s dangerous is because it’s wrong. Imagine you’re 8 years old again. Remember when your parents told you about Santa bringing you presents? That’s pretty much every financial advisor. I’m the overgrown 3rd grader who sits in the back and tells you for the first time that Santa isn’t real.
Let me show you why…
But first, a history lesson…
I wanted to introduce you all to a graph that’s very well known in the finance world. It shows the return of various assets over time.
You’ll notice that at the very top is our small-cap stocks. You’ll also notice that those stocks are the most volatile (they’re the ones with the “squiggliest” line). However, over time, they return more than any other asset class. As you go down the right hand side, you should notice a relationship. The further down you go on the graph, the smoother the lines become.
This is where the concept of risk vs. reward comes from. The more risk you take on (the more volatile/”squiggly” the asset) the higher return you should expect over time. So looking at this graph, if you put all your money in small-cap stocks back in 1926, then by 1933 you would have been more fucked than a prostitute with three tits. On the other hand, had you invested in government bonds, you actually would have seen a safe, and positive, return.
But let’s look way to the future. Had you invested a dollar in 1926, hopped in a time machine and visited 2013, you would be looking at over $26,000 vs. just $109 for all that time. So as long as you have the time horizon to ride the waves, more risk will yield better returns than lower risk.
This graph illustrates a super important concept: the longer you hold risky assets, the more likely it is that you’ll see a high positive return. The shorter you hold them, the more likely it is that you’ll see a severe dip in value. With less risky assets, you’re less likely to see a decline in value, but over the long term they will never have the same rate of return as risky assets.
I’m still confused…
Simplified: Risky stocks are the girlfriends that are way too hot for you. Sure, it’ll be awesome dating a hot girl, but you’re in for a volatile ride. Heated fights, mind games, and incredible make-up sex. Less risky assets are like the girlfriends that are a little more “brown paper bag”. They won’t be nearly as exciting, but are bound to be decent partners.
Ladies, I’ll write an equally as offensive comparison in the next article for men. Promise. 🙂
YOU don’t determine your risk appetite
There’s this theme in personal finance that your personality has a lot to do with what financial risks you should bear. For example, if you don’t like roller coasters, flying, or speeding, then that must, by definition, mean that you don’t have a large risk appetite. Therefore would be better suited to low-risk investments (things like bonds, treasury notes, etc.)
On the other hand, if you’re a daredevil that has spiky hair, a motorcycle, and a bad attitude, then a 6 month old Biotechnology company that hasn’t even applied for FDA approval would be most appropriate for you. After all, you’re a badass. Your hair is spiky.
Except that this isn’t the way it works at all. Here’s the key takeaway for today. Get out your pens and some paper, this will be on the test…
There, i’ve said it. Let all the angry financial advisors rain down a holy hell of resistance and dissent to that idea. But it’s absolutely true. And I’m going to prove it through some mathematical examples.
Why does time determine risk appetite and not personality?
Well, it’s all great and fine that you’re making financial decisions that are allowing you to sleep. But just because the decisions you make regarding your portfolio don’t cause you to toss and turn doesn’t inherently mean they’re good choices. On one hand, you could have someone who’s not taking enough risk and feels safe and loses a ton of money to opportunity cost. On the other, you could have some psycho that’s investing money in super risky stocks, but the cash he’s investing is to be used on a house closing in 3 weeks.
Again, just because you’re cozy in bed doesn’t mean that you’ve made the right decision. It might just mean you mind-fucked yourself into a good night’s sleep.
What happens if you follow old advice…
Like I said before, the old fashioned advice is so out of date that it can really hurt your overall financial picture. Here’s how:
Example 1 – Terrance is 27 years old and exactly what you’d expect from an accountant: soft spoken, reserved, and never does anything out of the ordinary (think Bilbo Baggins at the beginning of “The Hobbit”). He meets with his financial advisor and goes through the quiz that shows him his risk tolerance. Turns out he has a risk appetite like a Victoria’s Secret model. His advisor then suggests that in order for him to stay sane, he should invest 75% bonds and 25% stocks. If he invests $5,000 a year until he’s 65, with a 5% return on the bonds and a 9% return on the stocks, he’ll have roughly $810,000. Not a bad chunk of change.
Except the purchasing power of that $810,000? With inflation, it’ll only be worth 265,000 of today’s dollars. So Terrance will be enjoying TV dinners, long walks for entertainment, and maybe a small vacation to visit the grandkids every couple of years. I don’t think that’s the way that anyone wants to spend their retirement.
Example 2 – Mary-Ann is textbook firecracker. When she’s not working as a lion tamer, she’s jumping off any ledge as possible with a parachute on her back or a cord strapped to her feet. Adrenaline junkie to the max, Mary-Ann was “totally fuckin’ stoked!” to learn from her financial advisor that her risk appetite rivals the appetite of John Goodman. She’s hitting retirement age soon, but thinks nothing of the amount of risk in her portfolio. She’s 100% in stocks, 100% of the way.
Except that its late 2007, and the recession hit’s her harder than Muhammad Ali’s left hook. And over the course of 17 months see’s her portfolio shed 50% of it’s value. So that $1.5 million she had saved up? It’s now down to $750,000, and she’s easily got 3-5 more years of investing to get back to where she was. Guess she’ll be lion taming for a few more years…
What happens if you follow new advice…
Example 1 – Terrance is 27 years old and exactly what you’d expect from an accountant: soft spoken, reserved, and never does anything out of the ordinary (think Bilbo Baggins at the beginning of “The Hobbit”). Terrance meets with his financial advisor, but tempers that advice with what he’s read from thecodetoriches.com. After all, it’s written by someone who’s very knowledgable, attractive and modest. He knows that he’s got a very small risk appetite, but knows that if he doesn’t take the appropriate risks, that he’s going to regret it later in life. He’s young, so any huge risks he takes right now will level out with his 40-year time horizon.
He switches it up, and invests 75% stocks and 25% bonds. With the same average returns as before, he’ll retire with $1.3 million. He’s earned over half a million dollars more just by using his time horizon to plan his investments, instead of his gut.
Example 2 – Mary-Ann is textbook firecracker. When she’s not working as a lion tamer, she’s jumping off any ledge as possible with a parachute on her back or a cord strapped to her feet. She meets with her financial advisor who tells her that she’s got a huge risk appetite, but she also reads thecodetoriches.com. Obviously, she rocks a lot. She could sleep at night knowing that her money was in risky investments, but she’s planning on retiring in a few years and needs to take a lot of her gains off the table.
Mary-Ann only saw a 10% decline in the value of her portfolio as she was appropriately allocated to less risky assets. She still had enough to retire on, though she would have appreciated more (she was going to go on a base-jumping tour around the world)…
So risk appetite is based on…
How long you have to invest. That’s it. Young people, with all the time they have to invest, should be invested in risky stocks. Older people, looking to retire at some point in 5-10 years, should be mostly invested in low-risk assets, like bonds and treasury notes.
Young people stand to lose out on really high returns if they invest in low risk stocks. In fact, you’ll never reach a number that you can retire with if you don’t. On the other hand, if you stay invested in risky stocks too long, you could likely find yourself watching your net worth erode the way traffic jams erode my will to live.
Risk Appetite – The Wrap Up
So today was a really unconventional way of looking at financial risk. While most advisors are going to tell you to invest only with what you’re comfortable with, I’m going to tell you to stop being a lil’ bitch and invest in a way that will allow you the returns to live well.
- Risk appetite is how much risk is appropriate for a person’s portfolio.
- Most advisors will tell you that this is based on personal preference.
- That’s a lie. A filthy, goddamn lie.
- The only thing that affects the amount of financial risk you take is your time horizon.
- The longer you’ll be investing, the more risk you HAVE to take.
- The shorter you’ll be investing, the less risk you must take.
I encourage you to challenge me on this, as I know this very much goes against the grain of what’s typical in finance circles. Should personality and psychology factor in to portfolio risk, or should you just let the numbers speak for themselves? Could you invest in stocks or bonds that match your timeline, but not necessarily your personality? Comment below!
Keep trying to crack the code,