NWP Monthly Digest | May 2021
Spring is in the air and…wait. Really? We’re 1/3 of the way through the year already?!?! Does it feel like that to you? This year seems to be flying by as we get our daily updates on vaccine numbers, the declining risks of transmission outside and less need of wearing masks outside, and ever so closer to something a little more normal. A year ago, it would have been hard to picture this light at the end of a very scary tunnel.
In our line of work, we spend a lot of time discussing the concept of risk. Personal finance and risk are almost synonymous with each other. Risk tolerance assessment questionnaires, risk mitigation with insurance coverages, the risk that you’re not saving enough…you get the picture.
Risk, as a general concept, is woefully understood and defined poorly. Inherently, we all know what risk means, but we’re not good at articulating it, and often times not good at avoiding it. I personally like the simple definition that Carl Richards from the BehaviorGap uses: risk is what is left over when you’ve thought of everything else.
Of the four major types of risk mitigation, using insurance is called Risk Transfer or Risk Sharing. You can also choose Risk Avoidance (don’t drive at all), or utilize Risk Reduction (wear a seat belt, cars with airbags, etc.). What you can’t do, however, is control the risk or make it go away. Those of you that have ever needed to buy flood or earthquake insurance know how expensive it can get as the likelihood of the risk occurring increases.
By law, we are required to have auto insurance before we can drive a car. The statistics are so well known on how likely we are to have an accident in our cars that we’re not even given the choice to accept that risk on our own without the insurance.
Life insurance is probably the easiest risk mitigation tool known to mankind. Everyone is going to die - that much we know. Risk, of course, is not the fact that we’re going to die someday, it’s the fact that we don’t know when we’re going to die. We utilize life insurance to cover us should that risk surprise us and take away our ability to provide for our family. That also goes for disability insurance which, for some reason, is far underutilized and of much greater likelihood to be needed…but that is a post for another day.
There is also the risk that we’re going to save too little or too much money for retirement/college/purchasing our first home, or simply the risk that we’re going to run out of money. We reduce that risk by creating a plan to save (as in, doing the math) and how to utilize those savings over the course of our lives and our children’s lives. Simply preparing and planning for things is one of the best ways to mitigate risks in the first place. Remember, once we know what it is, it’s not really a risk anymore. See Mr. Richards’ definition of risk above.
Probably the most notorious risk in personal finance, however, is the notion of risk in the stock market. The countless conversations that we have with clients on risk tolerance, what a “risk asset” is, or how risky the stock market can be - trumps everything else we discuss by a wide margin. Much like the cost of insurance going up as the likelihood of a risk increases, the potential return on investments should go up (at least in theory) the more risk that you take.
Is the stock market risky? I’d ask you, “compared to what?” And what’s your definition of risk? See, it’s not so easy. And the reason that the stock market provides such appealing returns is precisely because of the risk associated with it. If people never lost money in the stock market, the returns would be much lower.
We hear very interesting takes on risk all the time. I was talking with a prospective client a few weeks back that explained to me that they didn’t like to take risks and “invested only in index funds". There is a lot to unpack here, but let me try.
Quick definition - index funds are mutual funds that invest their pools of money in certain types of securities, like stocks or bonds, without a human or computer actively making selections of the investments that they think will perform the best. A great example, of course, is the S&P 500 index or the Dow Jones Index that you see reported on your nightly news.
If you buy an S&P 500 index fund, are you really taking on less risk? Less risk than what? You're still investing all of your money in the 500 largest companies in the United States, ranked by market capitalization. The diversification certainly helps, and I suppose that’s much less risky than buying a few shares of Tesla, but you’re still investing your money in the stock market.
And when investing your money in the stock market, there is another very important component to the amount of risk your taking - how long you intend to hold that investment. Because your time horizon is the best Risk Reduction tool you have in your toolbox, alongside the diversification mentioned above.
A simple exercise I like to do with clients is to explain the probability that the stock market will be up or down next Monday. It’s basically a 50/50 proposition, like a coin flip, on any given day. It can go either way, and we waste a lot of time trying to predict that outcome. As you hold your investment for one year… then for five years… then for 20 years…the probability of losing money, or the risk of losing money, gets lower and lower. In fact, there has never been a 20 year period in history where the stock market has produced a negative return. Pretty sweet Risk Reduction tool right there, and all we had to do was stay patient and stick to our plan.
Here’s another way of looking at it, graph courtesy of Ben Carlson from Ritholtz Wealth Management: US Stock market returns, by year, since 1926. The stock market has had a positive return in 70 out of 95 years.
Perhaps you’ve heard the story of Harry Houdini. If you haven’t, I’m not sure I can do it more justice than Morgan Housel, one of my favorite writers, did last year.
“One of his famous tricks was letting big men punch him in the gut as hard as they could. Houdini – an amateur boxer before becoming a magician – said he could flex his muscles in a way that could absorb any blow. The stunt matched what people loved about his escapes: the idea that his body could conquer physics.
One day in 1926 Houdini was resting in his dressing room after a performance when a group of students from McGill came in to visit.
One of the students, Jocelyn Gordon Whitehead, asked, “Is it true, Mr. Houdini, that you can resist the hardest blows struck to the abdomen?”
Without warning, he then began slamming his fist into Houdini.”
~Morgan Housel, The Collaborative Fund
Houdini would die a day later from a ruptured spleen, “almost certainly from Whitehead’s blows”. You can read the rest of Housel’s brilliant piece here. It’s a terrific way to understand different concepts of risk.
Risk is what’s left when you’ve thought of everything else. Risk is, very typically, what you don’t see coming, and while we can’t control it or make it go away, we can do our best to be prepared for some of it.
Noble Wealth Pro Tip of the Month
Tax day is fast approaching. What, you say? I thought tax day was last month, in April. If you don’t know by now, the IRS moved tax day back to May 17th with little fanfare based on the number of people I talk to that are surprised by this fact.
That also means that the deadline to fund IRAs, Roth IRAs, SEP IRAs, HSAs…they all moved, too. This is great if you thought you missed your opportunity to fund your retirement contributions for 2020…even greater if you’re over 50 and you can utilize the “catch-up” provisions and save even more.
If you’re still futzing about the house and procrastinating finishing your taxes or deciding whether or not to contribute to your IRA, time is running out!
Things We’re Reading and Enjoying
A Short History of Nearly Everything | by Bill Bryson (Book)
One of the world’s most beloved writers and New York Times bestselling author of A Walk in the Woods and The Body takes his ultimate journey—into the most intriguing and intractable questions that science seeks to answer.
In A Walk in the Woods, Bill Bryson trekked the Appalachian Trail—well, most of it. In A Sunburned Country, he confronted some of the most lethal wildlife Australia has to offer. Now, in his biggest book, he confronts his greatest challenge: to understand—and, if possible, answer—the oldest, biggest questions we have posed about the universe and ourselves. Taking as territory everything from the Big Bang to the rise of civilization, Bryson seeks to understand how we got from there being nothing at all to there being us
(Don’t) Fear the Reaper | by Genevieve Roch-Decter, Grit Capital (long-form blog)
The founder of Grit Capital goes into a wonderful discussion on inflation, how it happens, and where it comes from.
“I’d like to caveat this newsletter by saying that I’m no PhD in economics, so this walk-through will be a gathering of views from people much smarter than I am.
So what is inflation?
Simply put, inflation is the decline in purchasing power of a given currency over time. One dollar buys less of a certain good in the future. Put another way - it is a rise in the general price level of goods and services.”
Until next month,
-Your team at Noble Wealth Partners
“There is nothing noble about being superior to your fellow man. True nobility is being superior to your former self.” Ernest Hemingway
