NWP Monthly Digest | February 2022
The word RISK, defined by the American Heritage Dictionary…
The possibility of suffering harm or loss; danger.
A factor, thing, element, or course involving uncertain danger; a hazard
The danger or probability of loss (to an insurance company).
Perhaps you define RISK differently in your head, even if you don’t know you’re doing it. How do you picture someone in your head that you consider a “risk-taker”? Do find them brave? Crazy? Out of control?
Do you say things like “that sounds really risky” without even thinking about it?
Evolution has had a very strong influence on our perception of risk. Reading about the “fight or flight” response system that the human brain has developed gives us a pretty straightforward vision into how we perceive risk and acutely stressful situations:
“The onset of a stress response is associated with specific physiological actions in the sympathetic nervous system, primarily caused by release of adrenaline and norepinephrine from the medulla of the adrenal glands. The release is triggered by acetylcholine released from preganglionic sympathetic nerves. These catecholamine hormones facilitate immediate physical reactions by triggering increases in heart rate and breathing, constricting blood vessels and tightening muscles.” ~Psychologistworld.com
In other words, our brain releases chemicals into our body when we believe we’re in danger, causing us to get nervous and anxious.
The risk of losing something adds a tremendous amount of stress to our brain because we are predisposed to avoid it. Our ancestors (you know, the ones that avoided losing things by avoiding risks) are the folks that passed down the DNA in our brain to create those types of responses in us today. They avoided risking their food, next month’s rent, and risking their lives for things that they ultimately felt weren’t worth it and they survived. We are hard-wired to avoid risk.
“At the end of the day, the only risk that matters in investing is PERMANENT LOSS OF CAPITAL. ~various Wall Streeters (bold letters for emphasis are mine)
What is “permanent loss of capital”? It means never getting your money back. I like the example of using your fictional cousin Johnny, who comes to you asking for a loan on his latest and greatest idea…a new, sure-fire, can’t-miss theme restaurant he wants to open in the bad part of town. We both know Johnny doesn’t know the first thing about running a restaurant, and I would define that particular loan as a sure-fire “PERMANENT LOSS OF CAPITAL”. Investing in a diversified portfolio in your 401k…well that’s a different story.
All of us that regularly invest our money in hopes of growing our account balances for something in the future have been lulled to sleep by a stock market that hasn’t done much but go up in the 13 years since the Great Recession. I often tell the story that Grant and I didn’t receive a single phone call from a worried client about their investment portfolio in March of 2020 as the S&P 500 cratered to a 35% loss from the previous highs…probably because most people were a lot more worried about other things as the pandemic begin to become a scary reality. But, when the stock market went down 5% in September of 2021, well that was a different story.
The statistics that are easily available on CNBC or anywhere you can google search “stock market in 2022” are much worse than that. Here is a summary of some of the “scary things” about investing I saw floating around online this month, the market’s worst January since 2009:
The S&P 500 flirted with being down 10% from the all-time highs (or what we will define later as a “correction”) - but two solid days of trading to end the month left the index down “only” 5.86%.
At one point, 1,400 stocks listed on the NASDAQ had been cut in half (down 50%), highlighted by Netflix’s 65% drawdown despite posting very solid results as a company. The NASDAQ finished the month down ~9% as a whole.
Cryptocurrency junkies started their second “crypto winter” as many folks liquidated their positions in everything from Bitcoin to Dogecoin - Bitcoin was down well over 50% from its high, and a lot of people felt vindicated after being told to “have fun being poor” because they were worried about investing in it in the first place.
Jokes about Peloton are everywhere, but one individual on Twitter (a trader) posted a great stream of consciousness that reflects the way a lot of us see risk in the market, “at first, when PTON was down 20%, I thought it was a great buying opportunity. When it went below $50 a share, I wanted to buy the whole company. When it went below $25 a share, I started wondering if it was even worth that much.”
The gold standard 60/40 portfolio (60% stocks, 40% bonds), long considered an ideal long-term allocation for many investors, was down ~7% at one point before the final two days of trading in January. Bonds did not provide their typical “cushion” this past month as they normally do, also suffering a pullback.
The most important thing you need to learn about investing is that risk and reward are connected at the hip, forever and for always. Since the beginning of time, investors have been searching for their own version of the holy grail - the investment/portfolio that goes up when the market is performing well and doesn’t go down when the market turns negative. But that doesn’t exist. Everything in investing has risk. Even making the decision to keep your money in cash carries risk as inflation will slowly (or more rapidly when it’s running hot like it is now) destroy your purchasing power.
“Risk is what’s left over after you’ve thought of everything else.” ~Carl Richards, The Behavior Gap
I find it very useful for average investors to have a little historical precedent on their side regarding the stock market, and using a few definitions or “rules of thumb” can go a long way to make you realize that everything is going to be OK. So let’s start by adding some definitions to different percentage draw-downs that the market will occasionally see (these are my definitions and loosely correlated to what you will see widely published). The term “market” we’re using here will be defined as the S&P 500, but it can apply to any stock market index.
A draw-down of less than 10% from the market highs = Normal operations
A draw-down of greater than 10%, less than 20% = Correction
A draw-down of greater than 20%, less than 30% = Bear Market
A draw-down of 30% or more = Market Crash
January, as bad as it felt, was nothing more than the market behaving normally. On average, we see market corrections once every two years. We see a bear market once every seven years (and almost universally accompanied by an economic recession), and a market crash once every 12 years.
Obviously, every market crash starts as a correction, moves to a bear market until it ultimately works its way to the very elusive and ultimate destination of market crash. The speed at which this happens has humbled even the most educated and experienced investors. As they like to say, “things happen slowly, and then all at once.” But it’s important to keep your cool as this barometer of stock market health hits these different marks.
For example, in January, the S&P 500 briefly entered correction territory. Is that something to be concerned about? Maybe, but not a five-alarm fire by any stretch of the imagination. Perhaps having a few of these definitions up your sleeve will help you navigate the invariably volatile stock market. Remember, the stock market goes up and it goes down…but it goes up a helluva lot more often than it goes down.
I’ll leave you with one more exercise. One of my favorite economists likes to say that “finding your risk tolerance during a market drawdown is like entering a boxing match with Mike Tyson without training”. It’s not easy and it’s not fun. You can take countless risk tolerance questionnaires, work with a disciplined investment manager, do everything right…but, at the end of the day, how will you feel when your account loses money?
You start with $100,000 and invest it on January 1st. Slowly, the market unfolds and by the end of the year, you’re down 20%. We’re in a bear market and your account value is now $80,000. You refer to the trusted definitions I’ve provided you in this blog, and you don’t change anything in your portfolio. We applaud you for your courage.
Next year, the market goes down 20% again. Now, your account is down 36% from where you started, and you have $64,000 left. How are you feeling now?
If you haven’t jumped ship, yet, the final leg of this hypothetical market crash is another year of a 20% drawdown, and now you’re down 49% and have $51,000 left. Will you soldier on? Will you fire your financial advisor? Will you do something worse?
A prolonged market crash has happened and could happen again. It’s why we always say that nobody has an ideal asset allocation of 100% stocks. Remember that the next time you look at your portfolio.
Noble Wealth Pro Tip of the Month
Simplification. One of my very favorite things to do is to help simplify things for our clients. Simplify your financial plan, simplify your investment portfolio, simplify your life.
“I would not give a fig for the simplicity this side of complexity, but I would give my life for the simplicity on the other side of complexity.” ~Oliver Wendall Holmes
When things get tough, going back to the fundamentals is a tried and true strategy in any endeavor, especially with your personal finances. If a 5.86% drop in the stock market had you nervous, perhaps things weren’t simple enough for you?
Is it time to go back to the fundamentals?
Things We’re Reading and Enjoying
How to Play the Guitar and Y | by Elvis Costello
I play the guitar. I’m not bad, but not nearly as good as my brother. This book is an incredible journey in understanding not just the fundamentals of learning to play the guitar, but why you would want to do it in the first place. By the way, this is an “AUDIO BOOK ONLY” recommendation. You can’t beat Elvis Costello reading this book to you on Audible.
This isn't strictly speaking an instructional manual, but a work of comedic philosophy.
Elvis Costello - songwriter, singer, author, and Fender Jazzmaster known to his admirers as “The Little Hands of Concrete” - spins his tale with wit, grit, and spit to spare.
How to Play the Guitar and Y, Costello’s new entry into Audible’s Words + Music series, combines recitation, impersonation, and musical illustration to show you how to turn a three-chord trick into a four-chord caper and let your curiosity take you where it will.
Part madcap musical method, part comic chronicle, How to Play the Guitar and Y is accompanied by the author throughout on a number of different instruments with his 10 wandering fingers.
What a World | by Morgan Housel, The Collaborative Fund
I’ve said it more than once in this space, but Morgan Housel is my favorite writer in the world. Don’t miss this one.
The CEO of Bronco Wine – which sells the Charles Shaw “Two Buck Chuck” wine at Trader Joe’s – was once asked how he’s able to sell wine for less than the cost of bottled water.
He replied: “They’re overcharging you for the water. Don’t you get it?”
A Simple Plan to Solve All of America’s Problems | by Derek Thompson, The Atlantic
If Morgan Housel is my favorite writer, Derek Thompson is pushing hard to move into that spot. Unfortunately, The Atlantic only provides you with so many “free articles” before you have to subscribe. Use them wisely and only read Derek’s stuff. This piece is pragmatic, apolitical, and spot-on. We used to be great about building things in America, and it’s time to do it again.
“During the holiday week, I spent a frigid afternoon standing in a long line outside the local library to pick up a rapid COVID test. Lines for essential goods are a pretty good sign of failed public policy. When food runs low, there are bread lines. Where gasoline is in short supply, there are gas lines. But there I stood, nearly two years into a pandemic, shivering inside a depressing metaphor of state failure. As I bounced from foot to foot to stay warm, I asked myself: How on earth did this happen?”
-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