Kathy

Hi, I’m Kathy Healy with Healy Wealth Management. Today we’re here with John Healy, our chief investment officer, to talk about risk. John, can you explain risk and talk about some of the types of risks that concern you as a portfolio manager?

John

Risk and investing refers to the possibility of losing some or all of your investment, or not achieving the expected return that you have for your portfolio, and represents the uncertainty associated with financial decisions and how they may impact your wealth.

And as Warren Buffett said, the first objective in investing is to not lose money. And the second objective is to not forget the first. I joke around sometimes. I say it’s Armageddon every day around here because we’re always thinking about risk. And let me say the first thing about investing that you need to pay attention to when you’re investing is risk.

There is no investing without thinking and analyzing and understanding, trying to get a handle on risk.

Kathy

So what are some of the other types of risk?

John

The most important, I guess, would be market risk. The general level of decline for the overall market, if the stock market crashes like the financial crisis. So we think about that, when they’re investing in stocks and they’re volatile, what volatility really means is losing money in the short term.

And the reasons why that could happen. Different risks that could cause. It would be concerns about rising interest rates, financial assets. Going down in price when interest rates go up. You know, interest rates are like gravity to financial assets. So the stronger the rate, the more it’s going to pull down the prices of the financial assets.

Interest rates are a big, big risk if we have higher and higher interest rates, that’s going to make stock prices, you know, certainly not go up as much. And they may come down quite a bit if we have big rate hikes. And that’s a huge risk. Our interest rates are managed by the fed. And they can print a lot of money to lower interest rates.

But that’s inflationary. So there’s this balance you know. If you start to see high inflation numbers that means they’re going to have to raise rates. And they can’t lower the rates to keep the economy going. These are the types of things on a macroeconomic level that people worry about that in Wall Street, you hear about it all the time. What’s happening with the fed and inflation growth in the economy. Those are things that people worry about that cause the markets to do what they do.

Kathy

What about currency risk?

John

Currencies. It’s relative, you know, country by country, different currencies. And that’s another factor in how different countries, different central banks are managing their, their money. If they’re printing a lot, you know, that can be inflationary.

And if they’re raising interest rates to slow down, you know, the inflation and the currency, people don’t really think so. There’s a lot of confusion about, you know, how that all works. I think different economists have different views. So when people say they’re worried about the dollar, the first thing they may be thinking about is relative to other currencies.

And that’s just, country by country. You know, it’s a dollar strong. It’s a dollar weak. That’s relative to other currencies. When you get into concerns that the dollar is going to no longer be the world’s reserve currency, there’s a lot behind that, what does that actually mean? It’s about the central banking system.

So, if you start talking about, you know, the dollar no longer working, concerns risk that the dollar may no longer be the world’s reserve currency. That’s not something that can happen easily. And I think there’s a lot of confusion about that. If the dollar no longer becomes the world’s reserve currency, we’ve got a lot more problems than that.

You’re talking about wars at that point. Major wars. So we are not going to give up control of the financial system reserves being in dollars. If we did, we would be essentially losing control over our ability to manage the economy and control over the country. So then at that point, you’re really talking about, you know, the end of the, the United States as we know it.

So there’s a point where when we talk about risk, when does it get to a point where you you just have to say that’s a risk. That’s just something that we can’t control. And you have to make a judgment at some point. Look, we assume that the United States of America, and I firmly believe this, that the United States of America is nowhere near ending.

We’ve got a long way to go. And just no way that this country is going to come to an end within the next 100 years. Anytime we make investments in businesses, the furthest we go out when we’re valuing a business is to assume that the company of really good company, you could say, might last 50 years.

I mean, there’ve been companies like Coca-Cola. I’ve used it as an example that, you know, it’s over 100 years old. Lots of companies, good companies have been around a long time. They’ve got a very strong, competitive, durable competitive advantage. And sustainable businesses that aren’t going are going to go away. You know, you can assume pretty easily that they’re going to exist for another 50 years.

We never go further than that with our assumptions. And we certainly would believe that the United States is going to exist for at least another hundred years, for sure.

Kathy

So what about liquidity risk?

John

So, if you’ve got too much in illiquid assets, you may be asset rich and cash flow poor. Sometimes we run across that where, you know, say an investor has got a lot of money and a high net worth.

But it’s all in real estate that’s not easily sold. And say you have rents coming in. Those rents may not be as much as you would think. So let’s say you’ve got a net worth of $10 million. But your properties, the way they’re designed, they’re not really renting out a lot. It’s just a lot of land or a lot of, rented property that has value, but it’s not generating much cash flow.

So, there’s not much liquidity there. You don’t have the money to get your hands on. And that’s what liquidity means when we invest for clients, you know, it’s only very rarely that we would invest in illiquid assets. And it’s only usually when the client really has a strong desire to do that with a small portion of their portfolio.

But, you know, we really focus on liquid investments. So with all these things to worry about, what do we do to help clients figure out what their investment objective will be? Risk tolerance is a function of your goals and what type of returns you need and how much short term volatility, how much short term downside is appropriate.

I think I’ve used an example of, you know, someone’s working and saving throughout their whole life. When they’re young, you can take more risk generally because you know you do have a longer time horizon. And you can if you’ve got 30 years before you’re going to use the money, whether it goes up or down, and you’ve got a long life ahead of you, a long career with lots of future earnings, you can have more risk.

And so you typically in the younger years you would have high risk. But as you get closer to retirement, it becomes a bigger and bigger nest egg. You’re running out of time to be able to take a big hit. So, you know, if you’re in your late 50s, you might not want to have all of your money in stock.

But that’s the highest growth we would do to have all your money and a good portfolio of good businesses that’s going to grow. That’s really the way to grow and beat inflation over time is to own a good portfolio of good businesses with pricing, pricing power, sustainable competitive advantage, all those things we talked about with our businesses. You know, once you get to be in your late 50s and you really decide, no, I’m getting closer to retirement, I really can’t ride out another financial crisis.

So in the short run, I want to limit my downside in the short run because if I had all my money in stocks, I don’t have enough money saved up to where I could take a big hit. So let’s say you need, I don’t know, $3 million. You really can’t go below that, but you only have 4 million.

Well, that tells you, you know, you could only go down 25%, so you really can’t take a full hit in the stock market in the short run. But if you had 50 million and you only need three, why not have it all in stocks? So I talk about that as when you’re saving for retirement, it’s like a rocket you’ve launched, you’re heading up in the atmosphere, and some people get to the point where they’ve saved enough, where they can retire, but they can’t continue with the risk.

They have to reduce the risk because now the earnings have, you know, their earned income has gone away. And so they really need that nest egg to be safer. But some people have built up their net worth so high that I would say they’re out of the atmosphere and they have enough. Even if we had another financial crisis and they had all their money in stocks, they’re basically out in orbit and there’s no way they’re ever going to hit the ground.

If you’ve launched up to a net worth where you have significant assets to where, you know, you can continue to have all stock portfolio that can be appropriate. So given all these things we could worry about, Kathy, how do we help clients determine the right investment objective?

Kathy

It’s a mix of psychology, financial situation and how much time you have before you need to use your money.

We collaborate with clients to find the right balance between growth and protection, and we make adjustments when circumstances change. So we work within a level of a scale from 1 to 5. 1 is less risky and each level grows in risk through level 5. For us, a level 5, which we call aggressive growth, is a portfolio invested in 100% stocks, usually 25 to 30 businesses that meet the stringent criteria of our portfolio managers and the universe of investments.

There are many, many, many things you could invest in that we would consider speculative and would be much greater in risk than the strategy we employ. A step down from level five is level 4, called growth, but it’s still a high tolerance for risk. It could be a mix of stocks and bonds or partially hedged stock portfolio.

Level 3 is called growth with income, and it’s a mix of stocks and bonds or a fully hedged stock portfolio. Level 3 is moderate risk tolerance, level 2 is low tolerance for risk and is called income with moderate growth, it is mostly bonds and treasuries. Level one is income with capital preservation. No stocks, only money market or CDs, and it is the most conservative lowest tolerance for risk.

So how do you know what your risk tolerance is? A good place to start is with an emotional check in. So how would you react to a 20% drop in your portfolio? A, panic and sell. B, feel uneasy, but hold. Or C, see an opportunity to buy, buy, buy. So here’s another question, do market fluctuations stress you out?

A, yes, I check my portfolio daily and I’m elated when it’s up and distraught when it’s down. B, I feel occasionally concerned, but I’m committed to stay the course, Or C, I focus on the long term and I’m unbothered by short term losses. If you’re trying to figure out what the right amount of risk is for you, don’t limit your decision to the emotional risk tolerance alone.

You could have a high risk tolerance that could lead you to bad results based on your circumstances, or you could have a very low risk tolerance that would hamper your long term growth. So in addition to thinking about your emotional risk tolerance, consider your time horizon and the need for liquidity. When will you need the money? If it’s within three years.

Safety and liquidity are key. If you have five or even ten or more years, you could consider more risk in your portfolio, potentially to achieve higher returns. A third consideration would be your financial goals. If your goal is to grow in preparation for retirement and you have a long time horizon, then you should lean toward a 4 or 5 growth or aggressive growth.

If your goal is to grow your wealth, to leave to your heirs or to a philanthropy, then growth or aggressive growth are also appropriate. If your goal is for your investments to keep up with inflation, then you could consider a level 3, 4 or 5.

A lot of times there are people on the radio that are talking about these topics and they are not fiduciary. They are not licensed like we are. And so they can say pretty much anything without a compliance department telling them what to say and what not to say. So I heard one of these guys say that stocks are riskier than mutual funds. Do you want to talk about that for a minute?

John

Okay, well, it depends on the mutual fund.

I really think whoever said that, what he really meant was having a diversified portfolio, whether it’s in a mutual fund or if you own it directly, your own individual investments in your own portfolio, that’s less risky than owning one business. There’s some there’s truth to that, for sure, depends on the business. But some businesses own diversified portfolios of stocks.

It’s not that simple. But don’t fool yourself if you own one stock the likelihood that you’ve got a lot of risk. That’s very, very true. There is an optimal level of diversification. And it’s there for a reason. Because you may think you know this business really well. You may be convinced that it’s a great business, but when you own just one business, there’s things that could happen just, you know, you need to diversify because you never know what could happen to that one business.

Kathy

So I hope that’s a good illustration of what we do here. If you’d like to have a conversation with us about the right investment objective for you, or if you have any questions, please don’t hesitate to reach out. We’d love to hear your thoughts in the comment section below, so don’t forget to hit the like button and subscribe to our channel.

Our mission at Healy Wealth Management is to improve the financial well-being of our clients by addressing your wants, concerns, and problems with wise counsel and sound investing. Thanks for joining us. We’ll see you on the next video.