Transcript
Paul Winkler: And welcome. It’s an Investor Coaching Show. Paul Winkler. How about that? How about that debate this week, it’s actually flying back into town, watching it on the way in text messages, going all over the place. What do you think about this problem? What do you think about that? I’m not here to talk politics. That’s just not what I do. So I was talking to a financial advisor earlier and she had a question for me about, you know, measuring risk in the portfolio. And, and so I said, well, you know, for me, it’s getting people to this idea of volatility, risk and volatility, making sure that they define risk.
Make Sure You Define Risk
Right. You know, when we talk about risk, I don’t mean risk in the way. A lot of you may think, I mean, risk, you know, people when, when you think of risk, what do you, what’s the word that comes to your mind? What’s the risk that I am going to lose my money? Right? And you know, if we look at investment markets, you know, what’s the risk of losing all of my money. If I have all my money in one stock, well, that’s pretty high seeing as the average company in the S&P 500 only stays in there for 18 years on average right now versus the used to be like 60 years. So that was a whole different deal. You know, if we look at 60 years versus, you know, 18, it’s, it’s a function of the level of competition that we have now, you know, it used to be that you had worldwide competition.
The US was the only game in town. And a lot of that, you know, think about what was a result of World War II. In World War II, a lot of Europe had been taken out and it was just massive, just an absolute mess. And Japan was a mess, you know, so we didn’t have a lot of competition. There were other countries around the world. They know capitalism was unheard of in many parts of the world. And that’s one of the things we don’t realize is just how much better things have actually gotten. I’ve talked about this before. If you look at the amount of capitalism that’s starting to spread around the world, you wouldn’t know it. You wouldn’t hear it by listening to the media or listening to anybody virtually that things have gotten better in that area, but they have been getting better in that area.
And, you know, as a result of the fact that it has, I’ve been getting better all around the world, there are various countries around the world that have been moving toward capitalism that never dreamt of it before America now has more competition. And it creates opportunity to, it’s not that gee things are getting, you know, getting bad or anything like that. You know, I think about the neighborhood that I grew up in and the people that I, you know, where I grew up in and just the level of wealth, you know, all around was much, much lower. You know, if I look at middle-class living standards back in the 1970s, and I look at living class, you know, the living standards of the middle-class now, I think it’s a big difference.
And, you know, that’s why you have a difference in the, if you look at the inflation rates of wages versus, you know, you have the social security cost index, and that’s based on CPI and that is the wages of people, workers and what the wages have gone up over time. Now, the reason they use that versus the regular CPI, which is based on prices going up, you know, consumer prices and how that has increased over the years, you’ll see that the wage CPI, which is what social security is based on is actually higher than the cost of goods and services.
Inflation Rates and Purchasing Patterns
Now people say, Oh, and you know, I don’t know. Everybody has a different inflation rate. Yeah, you’re right. We all do. And that’s, that’s very, very true. Everybody’s inflation rates are different because your purchasing patterns are different, but if you just, in general, they take a basket of goods and they say, well, this is a typical basket of goods. And if you look at wage rates, they’ve been going up faster. An economist was talking about the standard of living, having increased over time, you know, historically, and part of it’s a function of technology and, you know, things that we have today that we didn’t used to have. I mean, you know, if you’ve picked up, if you wanted to get information back in the 1970s, you called information.
And, you know, I remember watching these TV shows and, you know, back in the fifties, you’d have a, a person they’d get on the line and you have to ask them a question. They’d have to go back into the library and research stuff, and then come back to the phone line. I mean, it’s just a huge difference in the way things happen now versus then, you know, I think about cars, my son goes, Oh, you know, Oh, dad, I really liked to have, you know, he talks about like a Ford Mustang or something like that. And I’m like, yeah, they’re cool. Yeah, it’s really nice. He better be prepared to work on it a lot. I remember when I was with my first vehicles and I think in the seventies, eighties with constantly something, I mean, I knew exactly how to change a carburetor.
I knew how to, you know, work on, on the plugs and change the plugs and the distributor and, and you know, what had to be done if I was having some, some problems with, you know, with that, or if I had to go and change my own brakes, that would be something I would have to do every once in a while. I’d have to get in there and pull the wheels off and change the brakes and, you know, change my own oil. But, you know, you still have to change oil in a car, but you know, all of the things that I used to do I used to be able to do by myself. You know, I used to be able to tune up by myself and you know, now forget it, it’s all computerized, but they’re a whole lot more reliable vehicles are a whole lot more reliable than they were back then. I remember in the early mornings, you get up and get out there to the car.
And if it was cold outside, I might have to go and stick a screwdriver in the carburetor in order to get it going. Cause I mean, maybe you flooded out or something like that in order to get the dog on things, turnover and start, and then run back out there and pull the screwdriver out. You know, those of you that are older, probably remember all of this stuff that I’m talking about. We just get really negative don’t we, Oh, just things are so bad, you know, they’re, they’re just terrible. And you know, they’re actually pretty doggone good but risk when we talk about individual companies. Yeah. It’s huge. It’s a tremendous amount of risk, even with a handful of companies, even a basket.
How You Measure Risk
And you can have a couple hundred technology stocks in the late nineties and have lost, you know, 80% of your money, even though you were diversified yet 200 different companies. But the reality of it is, is that that’s a tremendous amount of it. Now, when we talk about market risk and that’s the system risk or the systematic risk is what we call it, which is the risk of being in the market as the broader that your diversification is, the more that gets smoothed out. Now there’ll be risks in certain asset categories. So if I look at, for example, like large US stocks, I can see that the risk of that is a standard deviation of 20.
And what that means is if my expected return is 10, then 68% of my returns. If I look at every year going all the way back through history, and I say, well, you know, what were the returns? What range of returns did we see in that asset category? And you would say, well, it was a standard deviation 20. So that means that 68% of my returns fell between 10 plus 20, which is 30% and 10% minus 20% is negative 10%. So that’s my range. And then if I say, well, okay, well that gives me 68% of returns. That means some returns fell outside of that. And if I want to go to the next 27% of returns and 13.5% above 13 and a half percent below gives me the second standard deviation out.
So in English, what I’m saying is that my return is 10. So I could have a 20 standard deviation that gives me 68% of my return. So I could be somewhere between, I could have a risk of a 30% return or risk of a negative 10% return. Well, I could have a return that’s between 30 and 50, or I could have a return that’s between negative 10 and negative 30. So take 10, negative 10 and subtract another 20. And that gives me that range. Well, that’s 95% of my returns historically will fall between those two numbers. That’s a pretty big range, 50 to negative 30, but we’re not done because we got 5% of the returns that are outside of that.
Now you’ve got years, like 2008, you got yours like 1929. You know, you’ll have years where there are some pretty significant events. But if you take that out and say, well, some of my returns fall out, how far outside of that? Well, you could have a 70% return. So take three standard deviations, 20 times 3 is 60 plus the 10 or minus the 10. Yeah, minus 60 is negative 50% return. So you could lose half your money. Well, if I want to reduce that sum, then I need to start diversifying more. And I can’t, I can’t have all my eggs in that one, large US stock basket.
And that’s what a lot of people have. You know? So you’ll hear when Trump says this, he kind of grates on me a bit, but you know, you could lose your 401(k). Okay. And, and I’m going well, you know, the reality of it is there are some companies that would do just fine. Thanks. And it would not necessarily be companies that you would have in your 401(k), but the reality of it, there’s, there’s some companies, but most Americans aren’t terribly well-diversified. So he probably has a point. A lot of people would lose significantly based on the way they typically have their investments divided out.
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The Stock Market Will Shift
So what do you do? Well, some of these areas of the market that when you start to add them in they’re smaller companies and value companies, you can reduce that standard deviation pretty significantly. You know, you might be able to get it down to, you could actually, for the same expected return, you know, historically I could take a portfolio with the same expected return and that portfolio would be holding like 40% bonds, you know? So you look at it, you think about, well, that’s a whole lot less risk, right? So if that’s the only return that I recall wire as an investor, that which was historically the S&P 500 has given me, I could get that same expected return with a fraction of the risk, how well by throwing bonds in, and the types of bonds that tend to move the opposite direction of the stock market when the stock market goes down.
So if you look at intermediate bonds earlier this year, when we had this market downturn and the first three months of the year, the first couple of months, it was pretty, pretty rough. When all of this information about COVID started coming out and all of a sudden the stock market started going down. Well, you had intermediate bonds actually shot up 10%. Now, other bonds may have gone up 1% to 2% or something like a lesser amount, but the point being that there were some bonds that really jumped significantly up in value when that market downturn occurred. Now, just imagine that I’ve got that in a portfolio. My standard might be down more in the neighborhood of, you know, 11% to 14% or something like that.
Well, that’s a pretty big difference. That’s a pretty big difference, you know, so now start doing the math and, you know, I don’t want to strain your brain too much, but you know, if we go in and look at the math on that and go say, well, what if it’s, what if it’s 11 now we got 10 plus 11 is 21. You know, that’s the top side, but now we go down to negative 1. Well, that’s a big difference between negative 1 and negative 10. And then you go up to, you know, you take that and say, well, you know, what’s the range of returns, two standard deviations out. Now we go up when we could have, we could have a 33% return and the bottom side is negative 12%. That’s a big, big difference between negative 12% and negative 30%.
You know, because if I’m down 30%, I have to have you think about it. If I’m down 50%, just to keep the math really easy. If I have a negative 50% return, which was three standard deviations out for the S&P 500, what does it take me to get back to even a 100% return? You know, so you got to have one heck of a big upside return. If I’m only down, only down, you know, 12% or something like that, it doesn’t take me that much of a return, you know, to get back to where I was to get back to my starting point. And that is part of why it is so critical to start to add some of these bonds in there and fixed income and other asset categories.
Now it’s not just bonds that diversify, you have value companies like when 2000 rolled around and large growth stocks went down, value went up, you know, you’ll have a lot of years like that. Historically speaking, where you’ll have value stocks go up when the growth companies go down, cause they’re counter cyclical sometimes not all the time, but there are enough of the time where it dampens the volatility. And even if they do go down together is to different levels. And you might have one area of the market goes down 30% and another area does go down, but it just, it’s just 10%. Well, that’s dampening the volatility. Good thing. You have that other stuff in there.
It Doesn’t Take Long for the Market to Recover
And that’s why it’s so key, you know? So if you look at things and say, okay, I get that. How about longer? Cause I am, you know, I’m a young person, Paul, you know, I, I don’t, you know, I don’t, I don’t worry about risk. Well, great. You can take a lot more volatility on and if you can do that, it can be helpful to you because you’re putting money in on a regular basis in your investment portfolio. When the market’s down, you’re buying more shares the market’s up, you’re buying fewer shares. So that works out really well. What if you’re on the other side though? And you’re saying, well, Paul, I’m older. I can’t take the market downturns. Well, you know, you can dampen the volatility some, but gotta realize though that even if you go through a market downturn, go all the way back to the depression and look at how long it has taken markets to recover during various recovery times after, after market downturns.
And the answer is a whole lot shorter than you probably think, you know, it’s 1973, 1974. You’re looking at well by the end of 1975, we had completely recovered. And I do a whole thing on this. I’m not going to reiterate it here because, but it’s really interesting. If you get a chance, you know, check out my website, we’re actually doing a blog on this, a written blog. And I walked through all of history, going back to the depression and walking through, not only how long did it take for market recoveries to occur, but why was it shorter than you think for it to recover now, as you can imagine, if you had the bonds in there it’s even shorter yet.
Why? Well, because one of the things that you’re doing during a market downturn is rebalancing the portfolio. Now rebalancing is an often misused term. I’ve seen investment firms use this term. We’re rebalancing your portfolio You hear them say that we rebalance portfolios. And then I look at actually what they’re doing. And it’s something called tactical asset allocation, which is they’re changing the asset mix based on a prediction of what they think is going to happen. Or they’re moving a little bit more money from large growth companies to more to value, or they’re moving more money from value to growth, or they’re moving more money from small to large. That’s not rebalancing, that is market timing.
But what I’m doing in reading the balancing is if I have a 60% stock portfolio and I got 40% bonds and stocks take a dive. Now they’re taking up only 55% of my portfolio and bonds are 45%. I’m going to sell off the bonds, you know, take that 5% overage and buy the stocks, which is the opposite of what your instincts want you to do. And you know, your instincts are like, you know, get rid of the stocks they’ve gone down. And I heard they’re going to go down even further. And you know, it’s, it’s just the opposite of what you instinctively might want to do. And that’s why so hard, you know, and a lot of times people do it at the wrong time. They may do the right thing, but they do it at the wrong time.
That’s pretty common. I see that. But part of the reason it helps for recoveries is you think about a way you’re doing, you’re selling high, relatively high for the bonds, and you’re buying relatively low for the stocks. So when stocks come back, you own more of them, which helps on the recovery even more and makes the recovery even faster for you. You know? So that what that causes is a reduction in the amount of volatility in the portfolio or the amount of time that it takes to recover. But there’s a second thing that I explained, I was explaining to the financial person that I was talking to.
I said, think of it this way, risk reduction occurs over time. Right. And she goes, yeah. And I said, do you know how to measure it? And she goes, not really. And I said, well, here’s basically what you do. You take your standard deviation, your risk there that we talked about. And let’s say that it’s 11% or, you know, whatever, let, yeah, let’s just use 11%. And let’s say that, that let’s say that your number of years is 16. You know, that you’re looking at a 16-year period. So I would go like this, I would say, okay, so 16, what’s the square root of 16. It is for now, if I take that 11 and I divide it by four, that tells me what my standard deviation is for the 16-year period.
Measuring Risk Stops Market Timing
And then you look at that and go, Whoa, it’s just, just under three right now. Instead of that return swinging down 11%, down 22%. You know, instead of having that wide wide range, now it’s only swinging by a much, much lower number. And that’s multi-year. So that is why when I talk about investing, when I choose an investment portfolio mix, except for little changes, as I get closer to retirement where I’m adding bonds, you don’t see me change in asset mixes. I don’t do that. You know, and the reason is, is because when I change an asset mix, because I’m thinking, well, you know, I think the market’s going to go down this market timing.
I’m assuming that the stocks are overpriced and they’re going to go down. Or if I’m going well, I think the market’s really going to take off. It’s going to really do really well. That’s market timing. And the other side I’m buying, because I think that they’re under priced and, you know, studies on market timing and success. It’s pretty few and far between people that actually help returns as a result. The vast majority of studies show that when people engage in it, they actually hurt returns. They don’t help returns. So you know, that to me is why it is so important to understand how to measure risk. If I know how much a portfolio can go up or go down, and I know that number, I know what it is for my investment portfolio.
And I know what it is for a multi-year period, too. That’s pretty cool. If I know that, then I can go, Oh, everything’s going as it should. Nothing’s out of order. And I’m not tempted to make changes when no change would probably be smarter. So I hope you understand. I hope that makes some sense as to why measuring risks. Yeah. So important. You are listening to The Investor Coaching Show.
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