3004: Risk Gets the Reward by Chris Reining on Investment Returns and Increasing Market Volatility

[00:00:00] This is Optimal Finance Daily. Risk Gets the Reward by Chris Reining of ChrisReining.com As a kid in the 80s and 90s, I remember begging my parents to buy VHS copies of Terminator and Predator. Who didn't love Arnold Schwarzenegger?

[00:00:18] It's easy to forget he got his start bodybuilding. That it was only after winning seven Mr. Olympia titles he wanted to be an actor. And it was only after becoming a bonafide action film superstar he wanted to be governor. I'm thinking nobody has three huge careers because it's the safe path through life. And so he must have a very high risk tolerance. This can only be learned through trial and error.

[00:00:45] It was a little surprise then to discover he's a long time investor. From Tools of Titans, quote, I felt if I was smart with real estate and took my little money that I made in bodybuilding and in seminars and in selling my courses through the mail, I could save up enough to put down money for an apartment building. I quickly developed and traded up my buildings and bought more apartment buildings and office buildings on Main Street down in Santa Monica and so on.

[00:01:13] I became a millionaire from my real estate investments. End quote. Schwarzenegger's life is a fascinating example of exposing yourself to risk and getting rewarded for it. After all, that's what investing is. You get rewarded for exposure to risk. That's why I'm always amused when people ask how they can turn $100 into a fortune without losing a dime. If there was a way to make money hand over fist with no risk, wouldn't everyone on the planet be rich?

[00:01:42] In reality, there's only two sides to investing in the market. Number one, stocks are ownership in a business with no guarantee of success. Number two, bonds are loans to such a business or government with no risk other than the risk they go bankrupt. How you approach constructing a portfolio of stocks and bonds is how most investors control risk and reward. The rule of thumb is to invest your age in bonds.

[00:02:09] Meaning if you're 30 years old, you put 30% in bonds and 70% in stock. At 70, you put 70% in bonds and 30% in stock. To say that another way, as you age, you're gradually shifting money from stocks to bonds, from more risk to less, from growth to safety. But the problem with any rule of thumb is just that. It's a rule of thumb. What age in bonds fails to account for is personal risk tolerance.

[00:02:39] For instance, what happens when a 30-year-old who's brand new to investing puts 70% in stock and then watches the market fall 50%? It's very hard to sit idle while 35% of your life savings evaporates. So it doesn't really matter what your age is, because what matters is your personal risk tolerance. In the Investor's Manifesto, author William Bernstein recommends the following modifiers to age in bonds.

[00:03:09] So very low risk, plus 20%. Low risk, plus 10%. Moderate risk, 0%. High risk, negative 10%. Very high risk, negative 20%. Here's how to use these numbers. A 30-year-old who has a very low risk tolerance, terrified of losing money, adds 20% to their age in bonds number.

[00:03:35] Instead of 30% bonds and 70% stock, their new mix is 50% bonds and 50% stock. On the other hand, consider a 70-year-old with millions of dollars they'll never spend down. They can afford a very high risk tolerance and subtract 20% from age in bonds. This is how 30- and 70-year-old investors can have the same 50-50 mix. Make sense? The problem isn't that seasoned investors don't know what their risk tolerance is.

[00:04:05] They do. The problem is when you're just starting out and have no clue. And the way to approach this dilemma is to imagine how you'd feel if you lost or gained money. In fact, that's what Harry Markowitz, who won the Nobel Prize for exploring the trade-off between risk and reward, said about his own portfolio. Quote,

[00:04:41] When you don't know what your risk tolerance is, maybe your best bet is to start with 50% bonds and 50% stock. And speaking of betting, the best poker players know that if they sit at the table and only play the nuts, hands that can't be beat, they won't play hands with a good chance of winning. The point is, if you insist your portfolio needs to be a sure thing, then you're naturally going to be risk adverse. And being risk adverse means accepting low returns.

[00:05:10] Safety is fine. Just be aware risk gets the rewards. You just listened to the post titled, Risk Gets the Reward by Chris Reining of chrisreining.com. I know we've all been there, setting those ambitious New Year's resolutions. By mid-January, most of us have already given up. But what if I told you there's one financial resolution you could actually stick to because it happens automatically?

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[00:07:48] In this article, Chris talks about determining risk tolerance based on how one responds to market dips under the assumption that a market correction means you've lost money. But I wanted to point out here that you only realize a loss in your investments if you sell them during a dip. When you hold onto those stocks through a market correction, you've lost nothing. If you're in your 30s and you're a long-term investor who isn't going to touch that money for many years,

[00:08:19] why are you even looking at it to know that there's been a market correction? I look at my portfolio periodically to calculate my net worth. But for the most part, I'm not paying attention to the volatility of my investments so it doesn't bother me one bit. I also look at the money I invest as a tax I've paid to myself. And I view that money as gone because it doesn't have any effect on my day-to-day life right now.

[00:08:44] Market dips are part of the rollercoaster ride of investing and they should absolutely be expected. In fact, you can see them as a good thing because now you can buy more shares at a discount. I think long-term investors can consider more risk because you have so much time to ride the rollercoaster of the stock market. The other thing to consider is your cash position. This, to me, is where my security and safety is.

[00:09:12] My strong cash position makes it even more unlikely that I'll need to tap into my investments anytime in the near future. And so I'm even more comfortable with the risk associated with a 100% stock portfolio. And that's a wrap for another Monday show. Have a great rest of your day and start to your week. And I'll be back tomorrow where your optimal life awaits.