Navigating the Retirement Risk Zone

Today I'm going to
share three critical ways to manage risk

in your retirement portfolio.

Whether you're fully invested
or you have cash

that has been sitting on the sidelines.

I personally believe
that you have more influence

over your investment outcomes
than you are being led to believe.

Now, the process and tools
I'm going to go over today are influenced

by my personal beliefs about investing,
but I do believe that they can help

you deploy your cash, reduce
risk, or shield from volatility.

But it all begins with an understanding
of some basic investing concepts.

So the first way to better manage

risk is to establish
a better understanding of risk itself.

General retirement investing wisdom has us
think and feel like risk is binary.

Something is either risky or it's
not risky.

And asset allocation - the concept -

reinforces this idea that risk is binary

because you either have money
on the risky side of the allocation,

or you have money on the safe
side of the allocation, i.e.

a 50/50 asset allocation would,
I guess, indicate that 50% of your money

is in risky investments and 50% of
your money is in safe investments.

Now, this is painfully false.

I suspect most people, including you guys
all watching this video,

know that that cannot be the case.

And yet most people still use asset

allocations and are still uncomfortable
with them all the same.

And I think that's because most of us
don't have the words

to put to that subconscious understanding
that risk is not binary.

So today I'm going to provide you guys
with a reframe of the concept of risk.

See risk is a spectrum.

There was this amazing movie
a couple of years ago called Free Solo,

and it followed this rock climber named
Alex Honnold, and this guy climbed 2000

plus foot walls in Yosemite
National Park without ropes.

So he did it completely free.

And one of the interviews in the movie,
he was asked about his view of risk.

The interviewer said, you know,
are you depressed?

Are you suicidal?
Do you have a death wish?

Because the interviewer
wanted to know, you know,

what could possibly make a person
take such great risk?

So the rock climber, his name was Alex.

So he very calmly and collectively replied
something to the effect of this,

“Though climbing this wall
isn't actually risky for me

because we need to redefine
risk into two parts.

There's risk, which is the probability
of something bad happening,

and then there's consequence,
which is the magnitude of the bad event.

So Alex continued by saying something
like, you know, I've climbed that wall

thousands of times over the course
of my life with ropes on.

And every night before preparing for this event,
I wrote down every handhold

and every foothold
and the exact sequence of the moves

that I was going to do on that wall.

I knew exactly what handholds
I needed to do that were shorter,

what were longer, what was I not going
to skip because I had no ropes on?

And he said
that wall may have high consequences.

Meaning yes, if I make one wrong move, I
fall to the floor 2000ft below and I die.

But that wall actually isn't risky for me.

I know it like the back of my hand.

And since watching that, I, Eric,
have specifically reframed

how I think about risk,
especially when it comes to investing.

See, it's actually quite helpful

to think of risk and consequence together
as two components of the same element.

Risk is the likelihood or probability
that a bad event will happen.

And then consequence is the magnitude
or the impact of that event.

So let me use a real life example
that we'll all have experience with right.

Flying on an airplane.

See, air travel is what we would call a high
consequence, low risk activity right?

If the plane goes down you're very likely
to have a fatal experience.

But planes don't go down very frequently.

And therefore we all think of this
as a low risk activity.

But the first person who ever flew on
a plane would undoubtedly have thought

that this was a ten out of ten
on the risk level, meaning

high probability of a disaster

and a ten out of ten on the consequence,
meaning a high likelihood of death.

But what happened is, as more people flew
on planes and air travel technology got better,

we got more evidence
that the experience was not actually

highly likely that things would go wrong,
despite it being high consequence.

And now we all fly on planes
everywhere we go

and think of this
as a completely normal activity, right?

The accumulation of historical data helps
provide a framework through

which normal consumers, like you and I,
can view an activity that might look

extremely risky to the uninitiated
or the less educated.

Things like driving a car, or flying
on a plane, or even starting a business.

And that historical data
can help us understand

the risk level and the probability
that something bad will happen,

but also the consequence level,
meaning the magnitude

or the impact of that bad event.

So now, armed with that knowledge,
we can dig into some core investment

concepts that lead to bad
investor outcomes and replace

those concepts with proactive methods
to manage risk and consequence.

So how do we take everything I've talked
about so far and make this practical?

We already highlighted how asset
allocations frame risk as a binary.

And we want to do away
with that type of thinking.

So let me use a real time
example of an investment allocation

that layers in this new way of thinking
about risk and consequences,

and should cause us to question
the use of asset allocation.

Let's say we have two people,

each with $1 million in a 60%
stock, 40% bond portfolio.

So they each
have the same amount of money.

They each have 60/40 portfolios.

Person one has the entire stock
side of the portfolio in just one company,

Tesla stock.

And person two

has the stock side of the portfolio
in a basket of 30 individual stocks.

So the question is which of those people
has the riskier portfolio

and which will have
the more consequential portfolio.

And the truth is,
without knowing what that second investor,

the one with 30 stocks holds,
we actually don't know

that it's any less risky
or any more less consequential.

But conventional asset allocation wisdom
would tell us that just by virtue of the

fact that that person holds 30 positions,
meaning they are less concentrated

and more diversified, that person
whose portfolio would be less risky?

Yeah, both portfolios are
in 60/40 portfolios.

But really, the truth is,

the only thing we can say based on asset
allocation is that neither portfolio

is clearly riskier or more
consequential than the other.

Holding 60% of your funds

in only Tesla stock will certainly have
a high likelihood of negative outcome.

Then holding 60% of your funds
in a Vanguard Value exchange traded fund.

But so too could Person
Number Two's portfolio,

the one with 30 individual stocks
be high risk and high consequence.

What if they're holding 30 single stocks
that are all small

cap companies that show no profit
and are completely debt reliant?

The issue here is that on the surface,
both portfolios appear to be the same.

They both have 60% weightings to stock and

in an asset allocation
financial planning tool,

they would look like the same portfolio
if you didn't look beneath the surface.

But it's obviously the case that not
all stocks are created equal in terms

of their potential risk
and their potential consequence.

Now, the same is also true for bonds.

And just because I didn't give

an example doesn't mean it's not true,
but it is actually true.

So while asset allocation
can sometimes be a useful tool,

it's actually really
not all that useful in my opinion.

This is why, despite constant reassurances
by the internet or brokerage companies

and even investment advisors,
you may still lose sleep at night

about your investments

despite of being in
“the right asset allocation”.

So what proactive data points
can we use to help provide us

with the evidence or knowledge
of how to identify the risk,

the likelihood of that bad
outcome of an investment such

that we can actually sleep well at night
with our retirement portfolios.

Well, I believe there are many options,

but I'm going to share
four of my favorite measures.

And those for are concentration,
exposure, variance and correlation.

So concentration tells us
how much of our funds are held

in one single investment.

So we've all heard the cliche
don't hold all your eggs in one basket.

That's undeniably true.

And using that example of Tesla
investor earlier in this video,

that would be an overly concentrated
portfolio, which increases

both the risk
and the consequences of the holdings.

But say that person were to hold 60% of
their funds in a money market fund, right?

That portfolio is also still too
concentrated.

Even though most of us wouldn't
think of it as risky,

but it does have high levels
of consequence and risk as well,

because it is both extremely likely
that a person will have tremendous

opportunity cost on the gains
they miss out in the market,

but also tremendous difficulty
getting back into the market.

Right?

We don't think about that too often, but
it does make that risky in consequential.

Now the second tool that we can use
is what I said earlier is exposure.

Exposure layers on top of the concept of
concentration and exposure gives us a direction

as to how much of a certain investment
we want to hold in our portfolio.

Increasing or decreasing exposure
to certain investments or sectors

can help us enter the market
if we have too much cash,

or it can help us reduce our risk
by reducing exposure,

if we're already invested in the market.

So, for example, say
you have 60% of your funds in money market

and you want to figure out
how to get from there

to investing your funds
into the stock market.

Well, you can start

by giving yourself low exposure
to a wide variety of investments,

and then slowly increase your exposure
to the riskier investments over time

as a way to get from point A to point
B, kind of like playing a game of Frogger

where you hop lane to lane to lane
to get across the street.

And the third tool at our disposal
that I mentioned earlier is variance.

So variance is also known
as standard deviation,

which is a statistical measure
that tells us using historical data,

what's the range of values
that an investment might trade within.

The higher
the variance, the wider the range,

and therefore the more variability
in the price of the investment.

So that means you may
get higher rates of return,

but you need to take on more risk
in order to participate.

Because if you want that wider upside,
you're going to have to accept wider

participation to the downside.

And we have historical data
that can give us estimates or expectations

of the variance of particular investments,
so that again, we can manage

both the risk meaning the probability

and the consequence, meaning the magnitude
of bad outcomes in our portfolio.

And finally,
the fourth tool is correlation.

Correlation
tells us the likelihood that an investment

will travel in the same direction
as the overall stock market.

It doesn't tell us anything
about the magnitude

of an expected move,
so it won't tell you

how much it will go up or down
if the stock market goes up or down.

But it can give us
some idea of the direction.

Now, stocks and bonds can have wide
ranging levels of correlation

to the market as a whole.

You know, some stocks are not actually all that
correlated with the broader stock market.

And in fact, some bonds are actually
highly correlated to the stock market.

So this idea that bonds
have been inversely correlated to stocks

and therefore holding bonds

is some kind of a diversifying
effect of stocks is partly true.

But you have to hold the right bonds.

And some bonds will act more like stocks.

And some stocks will act more like bonds.

In terms of the correlation benefit

they provide in an investment portfolio.

Which, again, is one of the reasons

why asset allocations are actually really
tricky and can oftentimes be misleading.

But historic data can provide
some expectation of which stocks and bonds

have what levels of correlation
to the market, so that we can construct

a retirement portfolio
that, again manages risk and consequence.

So the key concept I'd like you to take
away from today's conversation with myself

is that just like rock
climbing will appear highly risky

to someone with limited experience,
investing feels

risky and highly consequential
to those of us with little experience.

And rather than just throwing caution
to the winds and using an asset allocation

or a three fund portfolio or some random
basket of index funds because we're told

that's the right way to go.

My opinion is that we should invest
some extra time and energy into obtaining

a better understanding of investing,
because that's what's really going

to provide the peace of mind

that most of us are looking for
with our retirement portfolios.

Now, I'm not telling you all to go out
and become an investment expert.

You don't need to spend 1000 hours
learning about this.

In fact, my advice is quite the opposite.

Go find someone who actually is an expert,
and then what you can do is put in

some of your own time to at least
get a baseline level of knowledge,

like what we've talked about today,

so that you can interview

the proper professional and hire them
if it's appropriate.

But at least based on the information
I've shared with you today,

you'll have a better idea
of what to ask a professional.

You can better qualify them
by asking them questions about what

they would do with your money,
beyond simply asset allocation.

If an investment advisor or a professional
can't explain concentration and exposure

and variance and correlation
of the specific portfolio and investments

they would recommend for you,

then it's likely that they know just
as little as you about those matters.

All right, so a couple quick notes
as I round out this podcast here.

The first is
I could really use your feedback.

I love this topic.

And I was thinking of turning this
into a more spreadsheet

heavy demonstrative style of video
that would go up on the main YouTube

Saturday videos with kind of visual
explanations and examples.

And the question I have for you all is
would that be of interest?

And if it would, please leave a comment
below or send me an email.

Let me know if you'd like to see this idea
in a more detailed version

in a future video.

Secondly,
if you like this idea or concept,

I have a whole series of videos
on my YouTube

channel called The Asset
Allocation Problem,

where I've discussed modern problems
with retiree portfolio management.

I really, really recommend
you head over to the channel

and watch that playlist in its entirety.

It's probably about 45 minutes.

Finally, if you'd like to learn more about
how we help our clients build confident

retirement plans and investment
strategies, you can visit our website at

www.thepeakfp.com.

Thank you as always for your time
and attention and see you in the next one.