Risk to the Upside

The first law of thermodynamics, also known as the Law of Conservation, states that energy cannot be created nor destroyed, it can only be transformed. Within investments, that same law applies to risk. To start, risk is a tricky thing to define. The financial world has settled on a measure of volatility called standard deviation. Although imperfect for a variety of reasons, standard deviation gives a quantifiable measure of how bumpy the ride has been which is a reasonable approximation for how it will be moving forward. But it is only the tip of the risk iceberg.
My two cents is that risk should refer to the chance that something happens that you don’t want to happen. For retirees, that risk is running out of money. For a college student, that risk is not finding a job with a salary that justifies the student loans that were taken out. For a cliff diver, that risk is…well, you get the idea. As a society, we have been conditioned to think that financial risk is checking our monthly statement and seeing a lower number than the month before. What if everybody is missing the point? Why do only a handful of people talk about the risk to the upside? Risk to the downside is intuitive and easy to understand – money which was once yours no longer appears to be so. Risk to the upside is much more abstract in an alternate universe type of mental exercise. Behavioral finance plays a big part in why we feel differently about these two scenarios. Due to the anchoring bias, where each new level of net worth becomes a new high watermark to be anchored to, humans are constantly measuring progress against that level.

To illustrate this bias, the S&P 500 was up 290.24% from its 2009 low as of September 21, 2018. Those of you invested in the market are acutely aware of what happened after that – stock prices saw a swift decline into the Christmas Eve low. As of 12/24/18, the S&P 500 was up 213.17% from that same 2009 low. Hypothetically, what if you had fallen asleep in 2009 and awoken on Christmas Eve to check stock prices? There would be no fear and certainly no turning on financial news to watch the latest “Markets in Turmoil” special. My guess is you would be quite pleased to see stock prices more than quadruple over that very long sleep. The point here isn’t to say park all your money in the S&P and fall asleep. Rather, it is to remind you to always look at the big picture and to fight that anchoring bias.

Let’s return to the notion of risk. In finance textbooks, the risk-free rate is typically the return on a government issued bond. This is somewhat of a misnomer for an individual investor with a “cash under the mattress” mentality. Inflation is a silent killer of financial plans and those who “don’t want any risk.” Unaccounted for, it gradually eats away at the spending power of your money which technically leaves you with less money than you had before. Mentally, it is the easiest risk to cope with because we trick ourselves into saying that we still have the same amount of nominal dollars as we did before. Inflation risk doesn’t even compare to the upside risk we spoke about before. I have talked to plenty of people who have been sitting in cash for years just waiting for things to calm down to get back into the market. This type of second-guessing is a paralyzing fear. Afraid to make a misstep, investors instead do nothing and jeopardize their growth potential. Like inflation, risk to the upside is invisible, but potentially catastrophic for a financial plan. To tie this back to the first law of thermodynamics, moving money into cash is not de-risking the portfolio. It is merely a transformation of the risks that one is bearing.

Investors are always searching for the optimal portfolio or investment strategy. The answer to this is resoundingly clear to me: it is whatever strategy you can stick with. Are you unsure what that looks like? Do you need an objective voice to help you through the tough times? One of our advisors is more than willing to help with this as well as any other financial planning needs you may have.