Risk Defined | Erik Averill, Justin Dyer | AWM Insights #76
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Episode Summary
Risk might be the most used word in finance. We hear it all the time, but many have no idea how to define or quantify it.
The reality is that “risk” is an umbrella term with different types of risk folded underneath it. Though many will define risk in terms of tolerance, looking at it this way can stifle your long-term growth opportunities. Instead, it can be better to view risk as the permanent loss of money.
How should you view risk in the framework of this definition?
In this episode, Erik and Justin define risk, and more importantly discuss how you should view it within the context of your life priorities.
Episode Highlights
1:04: News you should know: China purchases a 1% stake in TikTok’s parent company, and TikTok was the most downloaded app last year. Adidas sells Reebok to Authentic Brands, which owns Sports Illustrated and the licensing rights to Shaq’s name, image, and likeness.
3:03: Amazon continues to disrupt the market by opening good old fashioned department stores.
4:26: True risk is the permanent loss of money that you can’t use in the future to achieve your life priorities. This definition is different from how risk is traditionally defined by advisors.
5:06: Most of the financial world will define risk in terms of tolerance; can you sleep at night when markets go down? This measure of risk can stifle performance by keeping people from investing in assets that have higher growth over the long-term.
6:29: Risk and return are related. If I expect to earn more, I should also expect to take on more risk.
8:43: Risk also encompasses regulatory decisions. Governments can make decisions that permanently affect industries; cryptocurrency being a great example.
10:38: If you’re taking a concentrated risk in an individual stock or cryptocurrency, you better get compensated for it. Does my return justify my risk?
13:00: You can cherry-pick examples of individual stocks that have performed very well over the past decade, but what are the true odds of you finding the needle in the haystack? What’s the cost of picking the wrong one?
16:39: Your life priorities should inform your investment allocation. Essential needs should be invested conservatively, while long-term priorities can be invested more aggressively.
19:45: Liquidity risk is a measure of how easily you can have access to your money. You should demand a premium or higher return on investments that are less liquid. Investments that are less liquid pose an additional risk, which you should be compensated for.
22:14: Risk is unpredictable, we know events like 2008 can happen, but we certainly don’t know when they will happen. Having a protective reserve that includes your spending needs is essential. This is how you prepare for risk.
22:42: Sitting on the sidelines and not participating in the stock market is also a risk. You risk not capturing returns that will outpace inflation.
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+ Read the Transcript
Erik Averill (00:00):
Hey, everyone. Welcome back to AWM Insights. It's Eric and Justin today, and each week we cut through the noise of what Wall Street is selling you to bring you the knowledge, skills, and access you need to invest like a pro. And today, we are going to tackle the topic of risk. This is one of the huge topics that when you sit down with an advisor, they like to ask you, "Are you risky or are you conservative?" And we think that is one of the worst questions that an advisor can ask you, because it is completely nuanced.
Erik Averill (00:36):
And so we're going to spend the majority of this podcast diving into what exactly is risk, but more importantly is by the end of it, you are going to leave this episode knowing exactly how to construct your investment portfolio to minimize the risk and give yourself the best opportunity to capture the returns you deserve. But as always, before we jump into that, let's talk about what's going on in the markets.
Justin Dyer (01:04):
So I'll kick it off here. Interesting stuff coming out of China, really rattling markets, and disrupting some investors emotions, if you will. China taking a 1% stake and TikTok's parent, which is ByteDance. I think we've talked about that a little bit in the past. ByteDance, or TikTok rather, was the most downloaded app last year, even in the US, more than Facebook, WhatsApp, and Instagram. That's a stunning statistic. Now, kind of as a result of this, US` lawmakers are calling for a block on TikTok again. We were dealing with that this time last year, I believe. You could put that in the category of regulatory risk, just a little teaser there. Adidas just sold off Reebok to a company called Authentic Brands for 2.5 billion. Authentic Brands own Sports Illustrated, and licensing rights to Marilyn Monroe, Elvis Presley, Muhammad Ali, and Michael Jackson. I mean, that's a pretty stellar portfolio there.
Erik Averill (02:06):
And the reason I think this is so interesting for us in this world is since July 1st, we've seen name, and image, and likeness, it's all over the media about college athletes being paid. Back in 2015, Shaq actually sold the rights to his name, image, and likeness, the majority of it for over $250 million to Authentic Brands. And so it's just an example of there is a power if you build the right business and brand, really for anybody, not just athletes, entertainers, influencers of. There is true value there, but just a fascinating situation.
Justin Dyer (02:47):
Yeah. That's some valuable human capital right there.
Erik Averill (02:49):
Whoo.
Justin Dyer (02:50):
I'd take that in a heartbeat.
Erik Averill (02:52):
It's also why you see Shaq on every bootleg commercial you've ever seen. You're like "Why is this guy on a Carnival Cruise commercial?" Well, he's got to make some money for his investors.
Justin Dyer (03:03):
Yeah. Going back to China, so there's been a big route in the technology shares listed in Hong Kong, kind of as a result of actually today, Friday, when we're recording this, China came out with some really, really strict privacy laws around what tech companies can hold about their customers, their users, and their apps, and whatnot. And it continued to push the market down. Again, that's that regulatory risk. Amazon is in the news again planning to tackle the brick and mortar once again, opening up good old fashioned department stores. You could also call that a risk if you're a holder of or an investor in something like Macy's. Right? Now Amazon is coming out after your territory again, and you thought that you kind of had that market cornered.
Justin Dyer (03:48):
So risk abounds pretty much anywhere and everywhere. And it's a very interesting topic to think about. Last piece I'll say, which is also risk related to an extent, is the Fed came out this week, well, the minutes of their meeting were released this week, and it's clear that they're signaling a reduction of their participation in the market. They're backstopping the market sooner than people initially had anticipated. It's not exactly clear when they'll do that, but they're starting to telegraph that that's going to be coming down the pike soon.
Erik Averill (04:26):
Yeah. And I think this topic is so important about risk, because if we take a step back and understand what we're trying to do with our money when we invest it is we've worked extremely hard for this money. You've worked extremely hard for this money, and you want to put it to work. You want your money to make you money. And so there's this understanding that you want it to grow, but you don't want to lose it. And I think that that's the ultimate definition of risk is the permanent loss of your money that you cannot use in the future to achieve your priorities.
Justin Dyer (05:05):
Right.
Erik Averill (05:06):
However, that's not typically the way that risk is defined or talked about in the financial world. A lot of times you'll sit down and they say, "How conservative or risky are you?" And what so many people are talking about is really can you stand to see temporary declines in your investment portfolio on a computer? And I think that the cost of having the wrong definition of risk is sometimes you're going to underperform. Your money is not actually going to grow at the accelerated rate that it should, because we as an industry have done a horrible job of actually educating you on what true risk is. And so you get scared, and you don't put your money where you should.
Erik Averill (05:55):
Then the misunderstanding is you in your own mind as an investor sometimes go, "You have your own definition of what risk is. Well, I don't want to see a temporary decline, so I'm going to go buy a single house, and that feels safer." But in truth we're going to get into some of these definitions of the type of risk. And so by the end of this, as we promise, is you're going to walk away with a robust definition of what true risk is, and then how to set up your individualized and customized structure to make sure that you're not missing out on the returns that you deserve, and also taking unnecessary risk. And so, Justin, bring us up to speed on what are the different types of risks? What are some of these definitions that we need to know?
Justin Dyer (06:39):
Yeah. Sure. So I think it's at first really important to start with the concept that risk and return are related. And that's kind of why we're talking about this. Eric, your points around how the average Joe typically thinks about risk is it's too simplified. It's overly simplified if you're doing things the right way, right? Your concept of, "Oh, can you stomach a 10% decline, or a 20% decline in your portfolio?" Right? It's dumbing down the conversation, and maybe even missing the forest for the trees, but to your question, what are some of the key definitions that you should know about here?
Justin Dyer (07:18):
Just keeping it kind of high level, you have things like regulatory risk. We touched on those in the intro in the news items where you don't know, you could be participating in a marketplace or investing in a country that has an unknown regulatory environment, or new regulations can come out of the blue, or in kind of a worst case scenario, and arguably we can say what's going on in Afghanistan is an extreme example of this, where the existing structures of a country disappear overnight. And so the regulations that potentially were in place, what? Two weeks ago? Are gone. They've vanished, and so now you don't know what that playing field looks like.
Justin Dyer (08:06):
Similar things happening in China with what they're doing with the technology companies. They're really clamping down on privacy laws, and as a result, tech index in China tracking Hong Kong listed shares is down something, I mean, substantial, over 30 plus percent. I think they're now officially into a bear market for the year. So that's this government, country kind of specific type risk where the regulations can certainly have a substantial impact on your investment.
Erik Averill (08:43):
Before you move on, is this also a concern in the crypto markets, where there's questions over countries coming in with their regulations of how they're going to handle cryptocurrency?
Justin Dyer (08:57):
Oh, yeah.
Erik Averill (08:58):
Does that fall in that category?
Justin Dyer (09:00):
Totally. And I think it's important. It's a great question, but it's also important to underscore that a particular investment has many sources of risk, but you're spot on with respect to crypto. You have a substantial regulatory risk, because essentially there's very little regulation in place right now. And one could argue that it's only logical to see additional regulation going forward from here. That might actually help, that might hurt. The jury I think it's still too early to tell on that one, but then you have things, let's just stick with crypto as an example, concentrated risk where you're participating in a single coin. Let's say you're invested in Bitcoin, and you can apply this to single stock investing as well, where you're putting all your eggs in one basket.
Justin Dyer (09:51):
And there's a very real chance that that can go to zero, a company could go bankrupt, or it can be acquired, or let's take the case of going back to Amazon planning retail locations. Right? You invested in Macy's because you think it was undervalued. It's underperformed recently, and you're like, "Ah, this is a great deal." Well, damn. Now Amazon is coming after our turf. Right? And so there's just so many different dynamics that come into this concentrated risk category. You highlighted going and buying a single property, that's one asset. That's exposed to so many things that are outside of your control, and that all kind of drives the risk component of that particular asset.
Erik Averill (10:38):
And I think where you mentioned this risk return is an important conversation, and it's making sure that if you're going to take concentrated risk, that you're getting the upside potential return for taking that type of a risk. And it's when we did the conversation a few weeks back about generating passive income, a lot of times individuals think, "Hey, I'm going to go buy one rental home, and I'm going to get some income coming in. And our issue is not saying that that couldn't be a proper model, but a lot of times the return, because you're actually worried about returns, not just the gross amount of dollars being paid in rent back to you, is not worth the risk of owning one particular home.
Erik Averill (11:27):
And so we had talked about for many of our clients, you have a diversified portfolio that when you're done playing your particular sport, or you retire from your job, or sell your business, at that time, we can start to turn on the passive income, but your risk has been spread across 10,000 individual companies while you're doing that. And then the other thing on concentrated risk, one that you may not even hit on here, Justin, because it's not thought about this way, is introducing leverage into this situation. So it's great that the positive side let's talk about concentrated risk, I own a home right now in this market. I bought it for 500, and now it's the craziest market ever, and I can sell it for $800,000. I'm like, "Hey, this is great." And then you have this leverage of the loan that you have on it. Right?
Justin Dyer (12:23):
Mm-hmm (affirmative). Yep.
Erik Averill (12:23):
The portfolio it's like, "Well, I actually only put 20% down, so I paid a 100 grand of equity, and now it's $800,000. I made money overnight." But the flip side of that leverage is 2008. Right?
Justin Dyer (12:37):
Right.
Erik Averill (12:37):
Now my house is worth less than the loan on the house, and so I think it's just that education of how they're married together. You may have hit on leverage, but I just think it's to your point, it's usually not simplified down to one type of risk when you're making a decision. There are different layers that you have to evaluate when you go into any type of investment.
Justin Dyer (13:00):
Yeah, exactly. And I would categorize that as somewhat called or something we call engineered risk. Right? You're adding artificial risk to an asset by levering it up. And maybe that's a good thing, maybe that's a bad thing, but one thing I think the critical piece to advance this conversation is, okay, well, you can never get rid of risk. It is part of investing. That's why we expect good returns over the longterm to participate in markets. Right? The two things go hand in hand, like we've said time and time again, risk and return are truly related. What you want to do is minimize the risk as much as possible, get it to a place where you really, really understand what is driving, what potentially could drive risk and volatility in your portfolio, and truly eliminate the permanent loss.
Justin Dyer (14:01):
I shouldn't say truly eliminate. You can't ever truly guarantee anything along these lines, but structure your portfolio, get your financial structure in a place where the risk, the possibility of permanent loss, is incredibly low. And then on the flip side, the probability that you're going to get the returns you deserve is incredibly high based on what we've studied in the past. Let's go back to this concentrated risk type conversation where you're in a single stock. And I can pick up a number of examples looking back where, okay, if you bought this company, Apple being one of them, if you bought this in 2006, whatever, let's just use as an arbitrary date. You look fast forward to today, hey, man, you're sitting pretty.
Justin Dyer (14:56):
But that company, and if you look at other companies that were in existence at that point in time, and you pick one of those, very many of them probably are no longer rounded today, or they had a flat return. And so the probability of you picking the right single stock, or the right single property to invest in and getting a substantial return is relatively low. So let's build a portfolio where the probability of you getting a very good return is incredibly high, and it just sets you up for success. Right? That compounding of wealth, the passing it on to generations, more of a known higher probability, higher likelihood outcome is really what we're searching for.
Erik Averill (15:44):
Yeah. And if we play this out, let's get practical, right? Let's talk about building a plan. One of the things that I always joke around is when I ask somebody, "Hey, are you risky or conservative?" The answer is, "Well, it depends, right? I'm very, very conservative when it comes to knowing that I want money to be able to pay my mortgage three months from now and feed my family. Very, very conservative. On the flip side, I'm not so conservative of trying to make sure I have money saved today to pay for some dream second vacation home that Sadie and I might have 30 years from now." Right? So in that standpoint is I am not either a conservative or a risky person. What I want to know is given my priorities, do I have the highest level of certainty to achieve that priority?
Erik Averill (16:39):
And so on this podcast, we have talked ad nauseum of something that we call a protective reserve. Right? Is the first thing we want to know is what is essential to you? What are your needs? What is your food, your clothing, your shelter, the things that truly help you sleep at night, that if COVID hits, and your job is uncertain, or just life throws you a curve ball, that you're not panicked. In life's most difficult moments we want you to be able to sleep at night and deal with the things, not worried about your investments or your money. And so the first thing is to make you bullet proof is going through this process, understanding what are your priorities? What are the things that you know I want to, and I need to be able to pay for these things over the next two to three years?
Erik Averill (17:30):
You take that money, we set it aside, people are terrified about inflation, inflation, inflation. Well, if you build your protective reserve the way it should be, you should not be worried about the short-term fluctuation of inflation. And so that's step one is getting that bulletproof protective reserve. Now you can have a different conversation for the priorities that you say, "You know what? These are wants. I really want these things to happen." An example for me is I would love to be able to pay for my three children's college education. Well, they are five, three, and 11 months old. Right? I'm not going to have to make those payments for a very, very long time.
Erik Averill (18:11):
And so in that situation, I hire someone like a Justin, and I say, "Hey, Justin, what is the evidence say is my best opportunity to be able to grow this money, to make my money work for me that the history actually shows I should have a high level of certainty that the markets are going to return money?" And I think that this is the difference. There is evidence I can put my money in a globally diversified liquid portfolio, as opposed to I could take that money and go try and gamble it away in crypto, or NFTs, or do some of these things, but I wouldn't have high certainty in that [crosstalk 00:18:51].
Justin Dyer (18:50):
Right. You're putting those priorities at risk, right? I mean, that's what it boils down to.
Erik Averill (18:55):
Yes. And I think that that's so helpful is the risk. I'd never thought about this until going back to real estate. We absolutely love real estate. It's in our public portfolios for our clients when appropriate. It's in their private portfolios as well, but someone in my situation, you all of a sudden, you start to go buy an extra rental home. It's not the risk that your renters move out, it's that you end up underwater. Right? You have too much leverage on a home, and now all of a sudden the house is worth less than what your loan is.
Erik Averill (19:31):
Literally, the thing about the public stock market, it goes to zero, you lose your money. If you're using leverage and loans in real estate, you can literally lose more money than you've invested. Right?
Justin Dyer (19:44):
Yeah.
Erik Averill (19:45):
So I think to your point of that permanent loss of capital, and then the last thing I would say is... You can interject before we jump into this topic. It's interesting in this market people are like, "Aw, man. Crypto, this, crypto that." We just saw the NBA first overall player take his signing bonus completely in crypto, but then they're like, "Oh, venture capital, that's super risky." So it's this fascinating thing of going, "Well, what makes something risky is liquidity, your ability for staying power, and what your priorities are." So first, bulletproof your needs through a protective reserve, then figure out what are your important priorities, and then your discretionary priorities. And we can actually lay out, hey, what is the evidence say is the best way to grow my wealth and minimize that risk?
Justin Dyer (20:38):
Yeah. And I'll just conclude or make my final statement that this is an important conversation. I know it's maybe not the most interesting. I think we can get into some really interesting aspects of it, but I mean, risk matters, and it's real. In the current environment it's kind of hard to wrap your head around it. What we talked about with what's going on in China, again, regulatory risk, actual impact to people's wealth. These stocks have really fallen off. It exists. You referenced 2008, 2009 in the real estate market.
Justin Dyer (21:17):
I mean, there were so many people that got wiped out, participated in the real estate market around that point in time. It is too easy, unfortunately, to get caught up in the moment. Let's go back to the crypto craze, stocks only go up, crypto only goes up, everyone is flooding, the system is flooded with money, asset prices continue to increase, and arguably people think that risk does not exist. And this is a good time to have this conversation I think because of that. That risk is there. It's not known when prices will correct, or when a new regulatory regime will come in and affect some asset or investment you have, or when an earthquake could hit, and you own a bunch of real estate in Southern California, as an example. Right?
Justin Dyer (22:14):
There's just so many unknowns and variables that can come into play, and so you need to be prepared. Right? And that's what we go back to with our financial structure, the protective reserve, the conversation around the priorities that are important to you and your family, and making sure that we have a plan in place for when, because it's not a matter of if, it's when risk comes into the equation.
Erik Averill (22:42):
And here's another definition of risk as we start to close out that we really want you to think about, real risk is not only the permanent loss of your money, but true risk is you not being able to achieve the life that you've envisioned. It's the priorities that you've set forth for yourself, for your family, and for the world at large, that if you don't get to achieve those, why did we do any of this? And so that's where this risk conversation is so important. And on the flip side, we've been talking a lot more of the negative coin of risk of trying to prevent it, but there's also the risk of being paralyzed and fearful. Right? And we can talk about this in future episodes of the fear that can cost you.
Erik Averill (23:31):
And I think about this as the fear of what's going to happen to public stock market because of the temporary declines. It feels risky, and so you sit on the sidelines. You're fearful that inflation is going to kick up. You're fearful about what's going to go on in the economy. And we have these episodes that we hope are powerful tools for you to fight that fear that says what time in the market patiently waited over the time is going to generate returns for you?
Erik Averill (24:00):
And so if you've been sitting on the sidelines since COVID. Right? Since February and March of last year, you've missed, literally, the markets have made over 100% since that time. And I know there are people listening to this, I know there are individuals, and it's hard, that have been sitting on the sidelines, and they're missing out on the growth of that, because they haven't sat down and gone through this financial structure conversation. Because if you're bulletproof in the things that you need to be bulletproof, then you get to participate in the market, and you get to capture these returns.
Erik Averill (24:32):
And so hopefully this episode has been helpful. I know we kind of stayed high level on a lot of this stuff. You can access the show notes over at awminsights.com. If you want to pour some more into these conversations, we would love to have those chats with you. You can contact us over on awminsights.com and of course, until next time, own your wealth, make an impact, and always be a pro.