How much money do you make? Not a good conversation starter in polite company. However, as a financial advisor, it's a question that I’m expected to ask in every first meeting.
It’s fascinating to hear the responses. I’m constantly surprised by the different income levels and corresponding careers. I’ve had the pleasure of working with clients making zero income all the way up to those making millions.
In my discussions, I try to accurately gauge how much risk they’re comfortable taking with their hard-earned money, which tends to be more challenging than it sounds.
When it comes to investing, I’ve found it’s important to think about risk in terms that are actually relatable. This is where a lot of financial professionals and DIY cookie-cutter approaches miss the mark.
No Free Lunch
Unfortunately, the price of high returns in the market is the excitement or potential terror of the ups and downs. Some people are thrilled by rollercoasters, while others prefer the merry-go-round.
I’ve found that most people don’t have appropriate expectations when it comes to risk. Everyone wants to be a hero and say that risk doesn’t bother them. The right answer is to be honest with yourself!
So, what’s the best way to determine your comfort level with market volatility? I’ve been in the advisory world for the past 14 years, and I’ve noticed a couple things about risk that tend to be overlooked. The first one is the size of the your portfolio relative to your income level.
Say you’re making $50k a year and, congratulations, you just received a windfall of $500k! If you had a 10% drop in your newly acquired portfolio, you would literally have just wiped out an entire year of your pre-tax income.
That’s much scarier or more painful than, say, someone who’s making $250k a year with the same portfolio. The person making $250k knows they can make that loss up within a year or two of working and saving.
In our society, we trade our precious finite time for money so we can enjoy our current lifestyles and squirrel away money for the future. It’s easy to have cognitive dissonance between your money and the time you spend earning it.
Time = Money
This is also a good way to look at big purchases. Don’t think about things in dollars and cents but instead ask yourself, “How many hours of work will this new watch cost me?” Or “Is that expensive weekend of fun worth an entire week of me slaving away?”
This doesn’t necessarily mean spending less or taking less risk, but it should be a consideration in your decision-making process. Likewise, say you just finished paying off your student loans and are making $120k – $10k per month – with a retirement account of $25k that you know you shouldn’t touch until you’re at least 60. Let’s say you self-identify as the merry-go-rounder or highly conservative risk-taker.
Does it really make sense to have a conservative portfolio? If you lost 30% or $7,500 in a few months, you probably won’t lose too much sleep over it. In the downturn, you would have only lost a single paycheck. In fact, if you’re a younger investor with a long-time horizon, you should actually be rooting for corrections so you can buy more shares at a lower price.
Wait, How Much Did i lose?
I’ve also found it’s better to think about risk in dollars and cents instead of percentages. Why does this matter? Well, percentages are more abstract, whereas dollars tend to provide a better gut check.
For instance, losing 20% of a $1 million portfolio doesn’t really sound that bad. But when the wheels start to turn upstairs, you realize that 20% equals $200k. That hurts a lot more than the benign-sounding 20% downturn.
And keep in mind 20% declines are the rule, not the exception, when you look at the history of the stock market. If you owned only the S&P 500 at the end of 2018, then you would have experienced an 18% decline in just a few months.
the big picture
Of course these are just a couple of the factors that skim the surface of a well thought out investment strategy. An important aspect of working with a financial advisor is that they understand your big picture.
There are plenty of cookie-cutter portfolios you can invest in online. But do those solutions really fit your risk tolerance or time horizon? Are you sure you won’t panic when the market inevitably has a downturn while the media bangs the doom and gloom drum?
I tend to hold a very optimistic outlook on the world and life in general. When it comes to guiding my clients in their risk-taking behavior, I like to adopt the attitude of planning for the worst but hoping for the best.
I was wine-shopping the other day and bought a bottle called “The Pessimist.” On the label, it said, “A pessimist is never disappointed.” I’ll be honest: I was a little let down by the wine.
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Patrick Dinan, and all rights are reserved.